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Euro Subordinated Bank Debt – Compelling Enough Yet?

25 August 2016 by Eoin Walsh

After the doom and gloom surrounding European banking stocks at the beginning of this year, not to mention the negative impact of the Brexit vote (both of which contributed to the Euro STOXX Bank index falling by almost 40% for the year to June 30th) it might come as a surprise to see so many analysts and commentators now talking up the opportunity in European banks, particularly in subordinated debt.

Focusing on equities for a moment; since the EU referendum vote, the Euro Bank index has rallied by over 18%, compared to just over 10% for the blue chip Euro STOXX 50 Index. Considering that Italy (still in the midst of its banking crisis) contributes the most names to this index (8 of the 30) and that the UK, where many banks have rallied by over 30%, is excluded, you can see why the sector is gathering so many headlines. However, despite the recent strong performance, the Bank index is still down by almost 30% YTD, compared to the STOXX 50, which is less than 9% lower and hasn’t been helped by the 13 financial names it contains.

Switching back to the fixed income markets, the ECB’s ongoing QE program has certainly helped performance, as has the contagion from the recent BoE stimulus package. However, we know that the impact of QE lags behind in those sectors not specifically targeted; the impact on Government bonds is obvious, as is the impact on corporate Investment Grade Bonds, now that they are being purchased as well. To give some context, the BoAML Euro Government Index has returned over 6.5% YTD, leaving the index with an incredible yield of just 17bps! This compares to a yield of 72bps at the start of the year – and remember ECB QE started almost 12 months previously. The UK Gilt index on the other hand still yields a whopping 72bps, and has returned a paltry 14.4% YTD.

Looking at IG corporates, the news is much the same – the Euro corporate index now yields just 62bp, with a spread of just 105bps, while the UK index yields 2.11%, with a spread of 136bps – slim pickings when you consider the indices have average maturities of 6.5yrs and 14yrs respectively.

So yield and spread are disappearing quickly in many sectors, but what about the opportunity in subordinated bank debt that we mentioned earlier?

To help with numbers we dived into our Observatory database system and came up with some interesting stats.

Euro-denominated subordinated bank debt still offers a yield of 3.6%, with a spread of 408bps, and with most of the names trading to spread-versus-Bunds (which trade at negative yields to the 10yr point), the bond spread is greater than the yield. Although obviously this ‘index’ will include a lot of old style Tier 1 and Tier 2 instruments, that are likely to be called over the coming years and are therefore trading at fairly tight levels. If we break out the selection further and focus on the Euro Contingent Convertible (CoCo) names, the yield increases to 6.8%, with a very attractive spread of 754bps; to give some context to this, the BoAML Euro HY index has a spread just shy of 400bps.

What is perhaps more interesting is how these spreads have moved since the start of the year; Euro HY started 2016 with a spread of 530bps and has therefore tightened by just over 130bps – the impact of QE is very clear. You would probably expect that Euro CoCo bonds have followed suit, but this is most definitely not the case. The CoCo ‘index’ started the year with a lower spread of 606bps and has therefore seen a widening of almost 150bps, despite the actions of the ECB and BoE QE.

Subordinated bank debt is not in vogue for many investors, and the CoCo sector in particular is viewed with suspicion, maybe not surprising following the sell-off in January and February this year. However this sector continues to be supported by the central banks and regulators, with limits being softened, including the all-important Maximum Distributable Amount (MDA) trigger, where rule changes have seen the buffer increase by 2% for most banks.

The biggest headwind for CoCo performance is probably the lack of an obvious buyer base, but with spreads of 750bps on offer, compared to 62bps for Euro IG or 400bps for Euro HY, it would seem that it can only be a matter of time before investors follow suit and agree with strategists and analysts and begin to put money to work. The opportunity is certainly beginning to look compelling.

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