The Year of (Corporate) Credit

Regular readers would recall that back in March we felt that Corporate Bonds offered a once in a decade opportunity. Since then, credit markets staged an unprecedented rally both in magnitude and speed, almost as head-spinning as the sell-off earlier in the year. We continue to believe that this will be THE year of corporate credit and expect further gains well into the end of the year.

The initial snap back was fuelled by a confluence of oversold valuations as well as a remarkable policy response that we felt eclipsed that of 2009 Global Financial Crisis. Since then, a number of key developments have transpired, which we believe are enough to propel a brand new credit cycle that would bring along medium to long term positive tailwinds for the asset class as a whole.

It is by now perfectly clear that the trinity of central banks (BoE, ECB, and FED) is aggressively targeting stability in credit markets so as not to hamper the liquidity of the corporate sector. The difference compared to previous central bank intervention is that this is not only confined to corporate bond Quantitative Easing (QE). Governments have extended the reach by also throwing a lifeline to weak borrowers with little or no history of access to credit markets, as well as through regulatory forbearance via the financial services sector that further fuels credit creation.

What we like about the current developments is the resolve by which the crisis has been tackled globally by policymakers and central bankers alike. The cherry on the cake would be the pandemic acting as a catalyst for deeper EU integration – something that has been improbable and divisive to date. A deeper restructuring of the entire economic area would be transformational for risk premiums. The recent Franco-German proposal, followed by the EU resolution to de-facto redistribute wealth across the continent, has all the ingredients to be that fundamental differentiator.

In addition, this is the first time in the past decade where we see a Global shift in the balance of power between creditors and equity holders. After years of unprecedented debt-fuelled dividend pay-outs and share buybacks, the tables may now be turning. Corporate Treasurers are keenly focused on raising as much liquidity as possible to insure their business operations should the markets seize up again, while also cutting returns to shareholders either partially or completely. Issuers are well aware that the return to normality can mean many things for their companies and the economic path remains very uncertain – all concerns we, of course, have too.

Nonetheless, along the way, we have seen a rally in investment grade corporate credit that has quickly eroded at least half, if not more, of the spread tightening potential that we identified in March. However, just as the market was pricing very little in terms of defaults back in January, we believe it is over-estimating these now. There is still a lot of fear, especially in the High Yield market, which we believe presents an attractive opportunity from a total return perspective. To that end, while the upside in A-rated investment grade corporates is not nearly as interesting as it was six weeks ago, we see plenty of opportunities for Cyclicals and what is perceived to be “riskier” debt to outperform from this point.

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A month to make your head spin

As you will have read, we have had one of the most dramatic (in speed and magnitude) three weeks of sell-offs in global markets, as Covid-19 fear spread globally and literally drove the world economy to a standstill. As people panicked, markets did too, hitting the sell button on absolutely anything that looked like it could possibly be liquidated. The carnage was so brutal and indiscriminate in bond markets, that often what is the most liquid part of the market – bonds with 1-2 years to maturity, not only sold off to wider spreads than its longer dated equivalent, but were also simply impossible to sell, in any size or package.

USD mid-March Credit Spreads (bps)

  1-3 yr 3-5 yr 5-7 yr 7-10 yr All
BBB 460 426 407 405 425
BB 940 803 725 656 743
C 1507 1180 978 859 1072
CCC 2692 1959 1576 1135 1828

Source: BofAML, data as at 19 March 2020

Systemic stress became so elevated at one point that even rock solid, risk free instruments such as US Treasuries, sold off (doubled in spread) in less than two days. Liquidity simply evaporated and there was no safe asset to hold, none. Credit markets were just too stretched by large fund outflows, making many market participants forced sellers. Perversely, this also resulted in bonds that were more liquid underperforming, as investors sold what they could leading to the inversion of the credit curves shown above.

It seems that initially the policymakers’ response was neither very swift nor coordinated, which escalated the market panic at the beginning of the month; but given the speed of market falls and spread of Covid 19 this is not really a surprise. It took several attempts from Global Central Banks and G7 try to put a lid on the carnage.  In the end, however, we have seen a very broad based mix of policy response, which we think puts a floor under credit spreads here. Direct fiscal stimulus is underway in almost every part of the developed (as well as Emerging) world now. Even in Germany. This will have a much-needed real world tangible impact on people and businesses.

To that end, we believe fixed income markets have emphatic systemic support to valuations.  We see investment grade corporate bonds in particular as an area when investors can improve the quality of their portfolios AND pick up a significant amount of extra compensation for it along the way.

To us, investment grade asset prices simply do not reflect true fundamental value or macroeconomic reality at the moment. In the ongoing hard and sharp economic impact that is spreading across the world due to the Covid-19 situation, investment grade markets have valuations that mirror the peak of the 2008-9 GFC and post the TMT bubble burst. Assuming Covid 19 can be contained we believe valuations are as cheap as anytime over the last decade and possibly future decades. There is no doubt that many businesses may not survive, as the impact that we are seeing today will fundamentally change people’s habits going forward. This is the beginning of a new secular shift that will permanently change industries such as healthcare, cash payments, travel or hospitality, to name a few. Being alive to these seismic shifts should prove a very fertile ground for active managers and outperformance.  

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UniCommerz; no…CommerzING; no…what?

We’ve previously commented on the now failed merger saga between Commerzbank and Deutsche Bank; there are now fresh new press rumours this week linking Commerzbank with both UniCredit and ING Groep. We struggle to see either strategic rationale or real-world practicality in any of these purported combinations. What’s clear is that Commerzbank is in a need of a radical solution. What is less clear is that either of these combinations can deliver it. Not only that, but we are wary that any theoretical tie-up would be detrimental to the investment theses of the cross-border suitors without solving the underlying structural issues for the German lender.

From UniCredit’s point of view, the appeal could be any and all of the following:

1) Increase presence in Germany and consolidate its local unit HVB with Commerzbank to achieve cost synergies.
2) Reduce funding costs long term if it manages to move headquarters to Frankfurt.
3) Gain access to the excess deposits at the Commerzbank level that would, in spreadsheet land, be revenue-accretive.

However, there are many more obstacles than opportunities in our view. To name just a few:

1) The lack of a single Deposit Guarantee Fund in the EU (and unlikely to get there anytime soon, if ever) will nullify Revenue synergies from the heavy deposit overhang at Commerzbank.
2) There is severe political opposition to exposing German taxpayers’ savings to purportedly inferior-quality assets in the periphery.
3) It will be very hard, if not impossible, to achieve cost synergies (“a lot of blood will spill before we merge with the Italians” – Verdi Union official and labour representative on Commerzbank’s board.)

Looking at a potential combination from the perspective of ING – the other rumoured “suitor” – it makes even less sense. The most obvious reason for a merger would be some sort of regulatory “arbitrage”. Dutch banks currently face a 3% core capital surcharge requirement imposed by the local regulator due to the size of ING in the financial sector compared to the Dutch economy. So, in theory, a move to being domiciled in Frankfurt and a reduction in the combined ING/Commerzbank entity relative to the size of the German economy would remove this Dutch requirement, creating a one-time windfall – freeing up excess capital. Furthermore, there continues to be a 20% bonus cap on the compensation of financial services professionals in the Netherlands, which is much stricter than the general European Banking Authority’s (EBA) guideline that applies for the rest of Europe. One could therefore argue that moving the headquarters to Frankfurt would financially benefit shareholders and employees alike, at least in the first instance. The main problem here is that this relationship would be a marked departure from ING’s current strategy of being a digital/innovation leader, with a branch-light and branch-less network across many countries. Interestingly, this includes its current operations in Germany, where it is among the few banks that actually generates return on equity (RoE) near its cost of equity, precisely due to its cost-light, branch-network-light approach. The secondary issue is that any merger will be ROE negative, hardly in the long term interests of shareholders and creditors beyond a one-time theoretical gain.

Let’s not forget that Commerzbank is a structurally challenged business rather than a prized asset that everyone is fighting to acquire. Hence, if there is any deal impetus, it is driven by Commerzbank itself rather than anyone else. Its less enviable capital and revenue position is partly due to past decisions of its own (curable organically), and partly due to the structural state of the German banking landscape (not curable organically).

The main appeal of a potential transaction, according to market pundits, therefore lies in the price.  Many say that Commerzbank’s 0.4x price to net asset value (NAV) is very cheap. However, expected returns on “tangible” equity of below 5% (using market consensus figures) do not make Commerzbank “cheap”.

Further accountants’ tricks around goodwill may sweeten the deal from a potential suitor’s perspective, but the European Central Bank may take a dim view of such shenanigans.

Overall, Commerzbank does have a problem to solve, and so does the EU banking system. The lack of a common Deposit Guarantee Mechanism (a.k.a. deposit fungibility) across the European Union prohibits the creation of a true single banking market – crippling the EU banking sector. Inability to eliminate excess capacity and reduce costs via cross border mergers puts the sector in a permanently lagging position compared to US banks. On top of that, there is the incredibly fragmented banking sector in Germany. This fragmentation challenges revenue growth and the cost base of thousands of branches creating an unsustainable cost base. These factors, along with a union vehemently opposed to any significant rationalisation adds further complexity. Without solving at least one of these factors, it will be extremely difficult for any German bank, including Commerzbank, to look competitive at a Pan-EU level. No type of M&A will supplant this fundamental truth.

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Santander: The ‘Old’ Normal, and the Pundits

“If everybody minded their own business, the world would go around a great deal faster than it does.” The Duchess, Alice in Wonderland by Lewis Carroll

I have been watching with amusement the recent swell of opinion from various market participants regarding Banco Santander and its upcoming first call date of the 03/19 CoCo bonds. These went from a definitive ‘no call’ just six weeks ago to ‘99.9% call’ ten days ago to being ‘outraged/shocked’ on the non-call event. Ominous statements such as ‘special place in hell for Santander’ and ‘severe implications for the AT1 market’ from otherwise reputable financial commentators followed.

Fast forward to today, Santander did not call the 03/19 CoCos, they did not drop 10 points, and the floor under the rest of the AT1 market did not disappear. And rightly so. Let me remind you that one of the defining characteristics of the CoCos is the lack of incentive to redeem (by, amongst other things, eliminating the ‘step up’ in spread that issuers have to pay after the first call date has passed). This removes the pressure on issuers to replace bonds at uneconomical terms. Back to Econ 101, this is in all investors’ best interest long term too. It is very simple to understand, yet I continue to be amazed by the number of people who fail to grasp it.

A quick cross-Atlantic parallel reveals a pretty similar, perfectly functioning bond market that has long operated on economic call premises (and continues to do so) but without the drama. Logically, there is absolutely no reason why it should be any different in Europe. If anything, today’s decision by Santander to skip the call (and I will ignore for now the theories regarding the technical nature of the non-call) is merely a sign of a maturing market, which arguably € AT1 has become.

Reputational damage arguments should have long given way to rational investment decisions. How much of a premium did Deutsche Bank have to pay when reputation WAS the main call driver? Why would it be any different now that economic call policy is the new ‘old’ norm? Banco Santander (and Credit Agricole for that matter) have been very vocal that it would be primarily an economic decision. This, combined with the particular structure of the bonds in question, as well as the current size of Santander’s AT1 bucket, ought to have left very little to the imagination regarding the call for anyone sporting a decent size calculator.

Thus I struggle to understand any investment decision built solely around the ‘reputational damage’ case. If you were surprised by the decision not to call, there is probably a better future awaiting you in a different occupation. If your investment case was solely based on ‘reputational call’, you are doing it wrong. If you don’t understand why it is better to replace debt with cheaper debt, not more expensive debt, you should go back to basics.

We at Kames aim to capture alpha by building investment cases around strong business fundamentals, attractive valuations, and compelling risk/reward, not around reputation. That said, the now busted call Santander 6.25% 19c may prove to have been a fairly interesting proposition down the line.

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Southern European banks headed north

One of our highest conviction views this year so far is that subordinated debt issued by southern-European banks is an attractive place to be invested. We are seeing bottom-up improvement, helped by regulatory zeal that still works in favour of bondholders versus shareholders, as well as a very strong technical picture.

In Spain we believe that the system as a whole is ripe for a rapid acceleration of real estate asset disposals by the local banks. We saw early signs of this trend in 2017, when Banco Santander and BBVA closed on large-scale transactions to remove the real estate risk from their balance sheets. We are of the view that this trend is not specific to these two names, but will spill over to the rest of the local banks.

In Italy we see the recovery as less-systemic and wide-spread versus that of Spain; nevertheless, the top two players have in our view improved sufficiently enough to turn the page in their credit recovery stories too, even if the challengers in Italy still have work to do.

From a regulatory point of view, there is a strong impetus to tackle the still high stack of bad loans in the periphery. Even without official targets, we see all Italian banks (bar UniCredit, which is already one step ahead) coming out of full-year 2017 reporting periods with updated three-year targets to halve the total stock of bad loans. This is quite a change in narrative versus the previous tone from local bank managers, and there is little doubt (in our minds) that this is a result of a close interaction with the central regulators as of late.

Broadly speaking, we have reached a turning point in the recovery cycle in Spanish (and partially Italian) banking systems. At the face of a stringent regulator, we reasonably expect that on one hand, the progress in credit health is solid enough to justify an overweight position, while on the other we still see ample room for balance sheet improvement. Therefore, unlike most northern-European banks, we continue to expect that the improving health of these financial institutions continues to accrue more to the benefit of creditors versus that of shareholders.

This means that from an investing point of view, we are very comfortable taking subordinated credit risk in the two markets. We continue to see the combination of a) a very strong technical picture in the asset sub-classes and b) the rapid improvement in fundamentals as not properly reflected in bond yields (versus comparable core European peers).

As always, good active management and strong issuer and credit selection will be key to optimising total returns in this space.

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Bank credit should be top of the list for income investors

The Global Financial Crisis (GFC) triggered fundamental changes to how the financial services sector operates. A slew of legislative frameworks ensued across most developed markets in an effort to prevent such a scenario from happening again. In the following years, the sector was subject to a plethora of new regulatory directives and frameworks on a global, regional and local scale. The common theme was ever higher capital requirements; the difference was how these would be met.

Fast-forward 10 years and most major global economies are in recovery mode (with varying degrees of activity picking up and unemployment falling). But the economic pain that followed the GFC is not forgotten – especially by the financial regulators. New and stricter rules require banks to hold ever more capital; it seems that each time the capital target is hit, the goal post is moved further away. From a credit investor point of view, this perpetuates a goldilocks scenario in bank credit: bank fundamentals are improving, but a large-scale redistribution of excess capital back to shareholders is constantly delayed due to the need to reach each new milestone, lowering the risk in bank credit.

As per the above, we are still in a regulatory convergence mode, and the end game is not yet in sight. What is certain is that banks’ fundamental profiles have strengthened significantly in the meantime. Most institutions now hold three times as much high quality capital compared to 2007, but this is not reflected in bond valuations. The spread on the junior-most capital layers of bank debt (the riskiest type) is five times more than senior unsecured bank credit (the safer layer), compared to just two times more in 2007. In terms of annual returns, the Bank of America Merrill Lynch Contingent Capital index achieved 5.8% in 2014, 6.9% in 2015, 7.3% in 2016 and 10.9% over 2017-to-date. The handsome yields on offer are also higher than bank equity, but with a lower volatility.*

As well as offering an attractive return profile, junior bank credit tends to have little discernible correlation to ‘traditional’ fixed income credits, as it is positively correlated to inflation and negatively correlated to interest rates. This offers investors significant diversification benefits using a building block fixed income approach.

Overall we believe that bank credit offers an excellent solution for those income investors that can look through short-term volatility and focus on annual total returns. As always, issuer and structure selection are key to avoid losses and capture the best income opportunities. At Kames we have a long history of successfully avoiding the losers in our high yield franchise, while our team combines over 30 years of fundamental bank analysis and research.

*Source: Bloomberg as at end July 2017, local currency returns. Bank of America Merrill Lynch Contingent Capital index ticker is COCO.Bank equity refers to EU Bank Equity Index’ dividend yield SX7P

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Europe not Spain executes Popular wind-up

Banco Popular’s equity and subordinated bondholders have been wiped out today. To come to this end, the EU’s Single Resolution Board (SRB) has exercised its power to resolve the Spanish bank after the ECB stating last night that the lender is ‘failing or likely to fail’. The exact mechanics follow a €9.1bn provisioning and capital shortfall being identified which necessitated the writing down of equity and AT1, as well as conversion of T2 debt into Shares of Banco Popular while simultaneously transferring that equity to Banco Santander for a total consideration of €1.

Some market participants have surely been taken aback this morning by the abrupt and radical way of dealing with a failing financial institution. After all, this is the first time when the relevant resolution authorities apply the widely-advertised Bank Recovery and Resolution Directive (BRRD) rules so in essence this is the first real-world test of the new playbook. As a reminder the BRRD was put in place a little over three years ago with an explicit target to limit market and public sector implications that have in the past ensued from a failing systemic financial institution.

In that respect, albeit relatively early to say, we can observe that the first attempt of breaking (or at least loosening) the bank-sovereign nexus seems to have been a moderate success. At the time of writing, the yield on the 10-year Spanish government bonds has hardly reacted to the event. In addition, not only are there no early signs of a broader market fall-out, both within the AT1 subset as well as across peripheral banks, but the broader market tone is actually constructive, with peripheral bank AT1s leading the gains.

The muted to positive market reaction to what many feared would be a catastrophe for a nascent asset class only one year ago illustrates several key facts; 1) investors are now much better educated on the risks and mechanics of the AT1 instrument 2) the regulators have come some way to address broader market concern regarding risks in these securities and 3) the strict application of the new resolution tools gives confidence that these are not just on paper but will actually be applied as intended in a uniform way.

That last point is very important in my view in restoring the ability to price risk in future similar instances and should reduce risk premia across the capital structure going forward. We still have fresh memories of widely diverging approaches in what looked like similar instances in the past (SNS Reaal, ING/ABN/KBC bailouts, Monte Paschi). It may well be too soon to say that these examples are surely a thing of the past, but for the time being the market seems to be taking exactly that view.