The Contingent Capital (CoCos) asset class has experienced a tumultuous start to 2023, rocked by the collapse of Silicon Valley Bank, Signature Bank, First Republic and Credit Suisse. The March events initially generated a dramatic re-pricing across the capital structure of global banks, with spread showing material widening in the senior, Tier 2 and AT1 space. AT1 securities, in particular, suffered from significant volatility in the days after the Credit Suisse event. Clarifications from various regulators around the globe however provided an important pillar t to assuage lingering doubts surrounding the asset class. The landscape has improved recently, bolstered by strong quarterly performance of EU and UK banks, a more resilient macro backdrop and a gradual slowdown of inflationary pressures. These have all supported a gradual recovery for bank capital. As a result, CoCos spreads have already started to tighten from the extremely wide levels seen in March, and the asset class remains one of the most attractively valued areas of the fixed income market.
The road ahead
So, where does this leave the asset class as we head into the second half of the year? Whilst a moderate and gradual deterioration in banks’ asset quality in H2 2023 and 2024 is likely, our view is that banks have significantly improved their fundamental position over the last 15 years, including a strengthening in lending standards, liquidity levels and capital position. In our view this will allow them to absorb the future increase in cost-of-risk associated with a potential economic slowdown in Europe and UK.

In fact, despite the idiosyncratic situation at Credit Suisse, the banking sector in Europe is probably as good as it has ever been when it comes to balance sheet quality. Banks have been deleveraging ever since the Global Financial Crisis, selling underperforming assets as demonstrated by average non-performing loan exposures decreasing from 4.5% five years ago to below 2%. We also expect the UK banking sector to continue to be resilient despite market’s concerns around mortgage refinancing risk and the potential slowdown of economic activity.

Liquidity and stickiness of deposits remain highly relevant topics after the turmoil seen in the US regional banking sector. Even on those metrics, however, European banks continue to exhibit good resiliency, with high percentages of insured deposits and clients less inclined to shift their savings to the money market space. A shift from current deposits to term deposits has also been a noticeable trend.

In this environment we think that Contingent Convertibles bonds (CoCos or AT1s) are currently trading cheaply on a historical perspective with a yield to worst above 9% (unhedged) and spread in excess of 500bps. Current relative valuations are also very attractive especially compared to the European and US “high yield” markets and also to US banks preference shares.
What this means for the Contingent Capital strategy
In terms of our CoCos strategy, we think it makes sense to look at gradually increase duration as we expect that central banks will have to shift to a more dovish rates policy in 2024 as the economy weakens and inflation pressure eases. We also think that credit selection is of paramount importance, and it is a good time to own higher quality CoCo issuers — to sacrifice a little yield if necessary to stay with the strongest institutions. We think that this will allow CoCo investors to lock-in very good yields without taking excessive risks in an uncertain macro environment and volatile markets.

From an issuer standpoint we keep our focus on strong national champion banks and low-risk institutions such as Building Societies in the UK always focusing on banks with large capital buffers to withstand potential earnings volatility. The regions we prefer are the UK (national champions and building societies), Italy (national champions), Spain (national champions and some smaller banks), which all remain areas of focus. On the other hand, Germany, France, Netherlands and Switzerland look less compelling to us. In Germany we see excessive SMEs and CRE exposure, while in France valuations still look relatively unattractive. We also find US financials unattractive due to relatively tight spreads for the larger institutions and weak fundamentals in the regional banking universe.

On single instruments, we favour shorter-duration products in order to manage recession risks and the potential impact on credit spreads in case economic growth will slow down. At this stage we see limited spread pickup in longer expected maturities as credit curves remain relatively flat. We favour high reset bonds due to higher resiliency at times of stress with the upside of potentially higher coupon in case of extension (non-call).

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