BoE stress test shows resilience of the UK RMBS market
Bank bonds have been amongst the best performing asset classes in fixed income over the last few months as they have rebounded strongly after the US regional banking crisis and Credit Suisse write down event in the middle of March. Indeed, since the beginning of April the COCO index has returned over 7% in comparison to European and US High yield both at ~3%. As we predicted bank fundamentals have remained robust ( Bank results should see levels begin to normalise ), however even though a recovery has begun, bank debt is still giving investors a very attractive premium over non-financial credit.
As we have now had the majority of European banks release their first half results, the themes of Q1 have continued: consensus beating Net Interest Margin (NIM) and profits whilst asset quality continues to be extremely resilient. Just as an example, we can have a look at Italy’s second largest bank, Unicredit. Their first half results were widely considered very strong – the NIM at 210bp was up ~60% YoY and profits were 25% higher than the market was expecting. Meanwhile, non-performing loans at the bank at 2.6% were still coming down from the previous quarter and the cost of risk at 0.05% persists to be at historically low levels. Their CET1 ratio came at an all-time high of 16.64% which translates into a whopping 689 bps distance to their Maximum Distributable Amount (MDA). As a reminder this MDA level is the capital level below which mandatory restrictions on dividends, AT1 coupons and variable remuneration to employees kicks in.
The huge reforms in the banking sector since the global financial crisis have shored up banks and in doing so they have become more depositor, and bondholder, friendly – and now in a higher rate environment bottom lines are improving too. The recent bank stress test demonstrated the progress that has been made by European Banks – in the ECB’s extreme stress test scenario, which included GDP falling by 6% and property prices by more than 20%, UniCredit’s Capital level would fall by 349bp – comfortably above the aforementioned MDA threshold. Just as another example of an issuer that has been unloved by markets at times, the stress test revealed Sabadell’s capital would fall by 374bp In the extreme scenario – much better than the 548bp fall seen in the last stress test two years ago.
Yet, these banks are still trading at cheaper levels than where they were earlier on this year prior to March. Investors can currently buy Unicredit AT1 debt at a price of 82.50, a yield of 11.4% in £ (11.6% in $, 9.7% in €) to a 2027 call and Sabadell debt at a price of 79, a yield of 14.2% in £ (14.4% in $, 12.5% in €) to the 2027 call. For those investors that worry about the potential for non-calls in the sector we would highlight July saw BBVA and Barclays call outstanding AT1 bonds, joining Unicredit and Lloyds who called their AT1s some weeks ago as European Banks maintain their strong record of calling bonds at first call.
And so, banks have done their bit in proving their strength – after the events of March the recovery was always going to be gradual, but markets should eventually normalise with spreads catching up with the price action we have seen in other spread products. With Western European financials having by far the highest upgrade to downgrade ratio globally, exemplified by Moody’s at 4.08 upgrades per downgrade so far this year, we think it’s only a matter of time before the strength in fundamentals brings about a more rationale pricing in bank spreads.