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.