European bank credit has come a long way since early 2023 when the turmoil faced by US regional banks and the spectacular collapse of Credit Suisse sent shockwaves around the investment community.

 

Credit spreads on European bank debt have tightened towards levels seen two years ago, following the brief blowout in the first quarter of last year, translating into huge gains for investors. We believe that’s a reflection of the robust fundamentals of the region’s lenders, which have improved considerably since the Global Financial Crisis (GFC).

 

Last year, the meltdown of Silicon Valley Bank and the wipeout of $16 billion of Additional Tier-1 bonds issued by Credit Suisse cast a shadow on European banks. Even as concerns of a potential contagion rattled many investors, we held to our conviction that the model of large European systemically important banks was way different from US regional banks.

Historical credit spread (OAS)

Source: Bloomberg. As of 5th of July 2024. Indexes are Bloomberg Western Europe Contingent Capital Index, Bloomberg Lower Tier 2 Debt Index and Bloomberg EUR Investment Grade Financials Senior Index.

It’s important to remember that the takeover of Credit Suisse by UBS as well as the crisis faced by US regional banks happened amid a rate hiking cycle. The European Central Bank (ECB) kicked off the first of a series of rate increases in July 2022 to quell the post-Covid surge in demand that caused a spike in inflation.

 

The rate increases helped bolster the balance sheets of European banks further as it helped boost Net Interest Margins (NIM) and overall profitability. Even so, impaired or non-performing loans (NPLs) have lingered around historical lows. Inflation has since then softened towards levels that central banks are comfortable with amid recessionary concerns.

Rate cuts looming

With the prospects of a rate cutting cycle rising, many questions abound in the minds of investors, including what that could mean for banks’ profitability and whether there’s room for spreads to compress further. In June, the ECB cut its Main Refinancing Operations rate for the first time since 2016 and in August the Bank of England too reduced its key policy rate. The US Federal Reserve is expected to follow suit shortly.

 

Over the past two years, the key beneficiaries of improved profitability of European banks have been equity holders as they received large dividend payouts and some lenders resorted to share buybacks. Even if rates normalise meaningfully from here, a modestly lower NIM as a result should mostly affect distribution capacity rather than the underlying capital position of banks.

 

Furthermore, many banks have managed to keep deposit rates relatively low in comparison to key market rates. A decrease in rates might also help in lowering interest burden and refinancing cost for both corporate and retail borrowers. This could mitigate a potential increase in impaired loans or NPLs and keep asset quality in a healthy territory. Estimates by European Banking Authority (EBA), the region’s regulator for banks, show that household NPLs may rise by 3% in 2024.

Loss absorbing mechanism

AT1s were at the centre of the Credit Suisse controversy last year. In the case of Credit Suisse, the fact that AT1 holders were punished by Swiss authorities even while something was left on the table for shareholders caused a lot of consternation. Equity holders typically rank below the subordinated bond holders.

 

However, European AT1s have held up well since that event, thanks to the EBA and the Bank of England, who were quick to distance themselves from the Swiss approach on AT1s. The performance of AT1s have also been underpinned by a vastly improved Common Equity Tier 1 (CET) 1 ratio, supported by higher retained earnings and in some cases lower Risk Weighted Assets. For European banks, the fully loaded CET1 ratio averaged 15.9% in 2023, comfortably above the average minimum requirements of 11.1% stipulated by the ECB.

 

AT1s are the answer to the politically unpalatable and economically untenable bailouts by European governments to save troubled banks in the aftermath of GFC. The loss absorbing mechanism of AT1s, a type of hybrid instrument first introduced in 2013, gets triggered if the issuing bank’s CET1 ratio falls below a pre-determined threshold. Typically, it’s either 5.125% or 7%.  If the ratio falls below one of those levels, the bonds can be converted into equity or written off completely.

Favourable technical factors

Although spreads in AT1 have tightened from the post-Credit Suisse wides, technical factors are highly favourable for investors and current yields remain compelling compared to standard HY corporate bonds. In the last five years, supply averaged about €30bn ($33bn). In the near term, we continue to expect issuance to be limited to refinancing and don’t expect annual supply to stray too far from the recent average.

 

In the first half of 2024, CoCo issuance stood at €23bn with many banks frontloading their funding plans to take advantage of the favourable spread environment, which could lend some support for spreads in H2. Total outstanding AT1 debt stands at about $210 billion, which includes issuances in U.S. dollar, Euros and Pounds.

 

Moreover, banks have been fairly active in the management of their capital structure. AT1s are perpetual in nature and have no final maturity as the capital maintained by banks are required to be permanent by regulators. However, most big bank issuers regularly redeem the existing bonds and replace with new bonds after the `non-call’ periods that range between five and 10 years. If the bonds are not called, the coupon on the AT1s are typically reset at a higher floating rate over a pre-determined benchmark.

 

Over the past two years, some small and medium-sized issuers have been resorting to an unconventional liability management exercise whereby issuers tender existing bonds in exchange for new bonds. This way they aim to achieve lower reset spreads and higher participation rate as existing holders are prioritised over new ones. Regulators have also allowed many banks to refinance when six months are still remaining in the five-year non-call period. 

Number of AT1 Tender Exercises

Source: Natwest Markets. Post 5 years: AT1s called after 5 years from issuance. Pre 5 years: AT1s called before 5 years from issuance.

Navigating headwinds through careful credit selection

In terms of country preferences, UK and Spain are still two of our favourites. In the UK, apart from the opportunities offered by the large systemic banks, we continue to see value in building societies. The recent takeover announcements of The Co-operative Bank by Coventry Building Society and the buying of Virgin Money by Nationwide Building Society are a sign of health for the sector, with reinvestment of strong capital position.

 

In the case of Spain, the country has weathered the energy crisis of recent years, thanks to a lower share of energy-intensive manufacturing. It continues to post a relatively healthy growth rate, and Purchasing Manager Indices (PMIs), a leading indicator of economic performance, continue to show better sentiment when compared to other European countries. The merger between BBVA and Sabadell is a key development that we are monitoring.

 

Overall, we take a tactical approach to investments in AT1s, depending on the desired outcomes. For instance, in the Jupiter Unconstrained Bond strategy, we see value in the income offered by short duration notes with near-term call dates and high reset spread in large systemic banks. We believe these instruments carry a high likelihood of call back at the next call date (often in the next 12 months) and consider them a good alternative to generic non-financial high yield in the current spread environment. In our dedicated Jupiter Financials Contingent Capital strategy, we see value in AT1s with low reset spreads if the issuing banks have good call track record and comfortable capital ratios.

 

As discussed, a range of factors including high interest rates, robust bank capital ratios and low NPLs have helped tighten the spreads of European bank debt since the tumultuous days of March 2023. While there could be headwinds ahead as a potential slowdown in economies prompt central banks to start cutting rates, we believe European bank debt would continue to offer many tactical opportunities, and careful credit selection will be key in the coming months.

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