Why is the banking sector spooking credit investors?
In the opening weeks of 2016, fixed income investors have had their faith in the banking sector, particularly in Europe, tested once again. What is causing the alarm, and is it justified?
Unstructured Learning Time
It should be noted at the outset that Europe currently stands out as a bright spot in the global economy, with improving employment and low oil prices helping to support the consumer.
European companies have as yet been more reluctant to increase debt compared with US companies.
Tighter regulation and de-risking have also broadly improved European bank capital; strengthening capital levels and making a lot of progress in repairing balance sheets.
Nevertheless, some banks have been able to make more progress than others.
A prolonged recession in the small business sector in Italy has meant that Italian banks have higher than average non-performing loans (NPLs)1, while Deutsche Bank’s reluctance to cut back on its universal investment banking ambitions and raise capital has made it difficult to materially reduce its balance sheet.
However, the recent volatility has not discriminated between stronger banks and those with extra work to do, and we believe this may have opened up opportunities for credit investors.
So why are markets nervous?
Markets so far in 2016 have become increasingly sensitive to the prospect of a global economic slowdown.
Although initially led by concerns surrounding China and the emerging markets, the recent slowdown of developed markets has now joined the list of worries weighing on investor sentiment.
High public and private debt, structural issues in the eurozone and a raft of political tensions have all shaken confidence and continue to provide headwinds to growth.
With China and the oil price sending out deflationary pulses worldwide, concerns have mounted that nominal growth is too low to have a material impact on that debt.
Furthermore, markets are worried that the limits of what monetary policy can achieve in supporting the global economy have been reached, and that central banks are no longer in control.
All eyes on the banking sector
Commodities and energy-related sectors were those most hurt in the fourth quarter last year and in January 2016. A prolonged period of low oil prices put many of the companies in these industries under severe pressure.
Investors now seem to believe banks are next in the firing line. Investors have grown very nervous about the exposure of banks to oil and other commodities.
Equity prices in banks have fallen sharply and credit spreads2 have widened, with subordinated debt widening the most.
Having performed relatively well in January, the global banking sector has become a focus for attention in February.
At the time of writing (11 February), the iBoxx EUR Senior Banks index was around 20 basis points (bps) wider, while subordinated banks were 86 bps wider month–to-date.3
We see the underperformance as predominantly driven by technical pressures – redemptions or sales by specialist funds – rather than fundamental analysis.
Recent headlines within the banking sector have not been helpful.
Novo Banco senior bondholders were effectively wiped out when the controversial decision was taken to transfer bonds from the “good bank” Novo Banco into the “bad bank” Espirito Santo.
The move was highly controversial, because it targeted specific bonds so that not all senior bondholders were treated equally.
The extended time period between the initial creation of Novo Banco and the transfer of bonds meant that the Novo Banco shareholders should have shared some of the pain.
In Italy, the European Central Bank (ECB) had requested information from banks on their NPL books as part of a wider analysis on NPLs on bank balance sheets.
The ECB had indicated that more needed to be done to provision for NPLs.
In Italy, where NPL levels are higher than average and provisioning lower, the local regulator told the Italian banks to disclose this request to markets, which was misinterpreted by the market as a warning by the ECB that they face intervention.
Given all of this uncertainty across financial markets, bank equity prices have fallen materially. So much so in fact, that the market has become increasingly worried that banks may be forced to cancel the coupons on their additional tier-1 contingent convertible bonds, known more commonly as “cocos”.4
Taking an objective view of the European credit market, we in Schroders’ fixed income team believe that European growth remains on track.
Consumer demand remains firm, illustrated by very positive car sales supported by the low cost of oil.
Meanwhile, European companies have not been as involved as the US in late-cycle financial engineering. As a result, leverage is relatively low compared with the US.
With this in mind, the recent widening of spreads has, in our view, created a buying opportunity - particularly in sectors where fundamentals remain robust, but that have still experienced underperformance.
So far in 2016, selling pressure has overshadowed any change in credit fundamentals. We think that, in time, cooler minds will prevail.
1. A non-performing loan (NPL) is a loan on which the borrower is not making interest payments or repaying any principal. At what point the loan is classified as non-performing by the bank, and when it becomes bad debt, depends on local regulations. Banks normally set aside money to cover potential losses on loans (loan loss provisions) and write off bad debt in their profit and loss account.↩
2. A yield spread is the difference in the yields of comparable bonds. If the spread between two bond yields becomes larger, the spread is said to widen; if it becomes smaller, it is said to narrow. The difference in yield between a corporate bonds and government bonds is referred to as credit spread.↩
3. Subordinated debt is ranked below other debt in terms of claims on assets. In the case of a default, the holder of subordinated debt (also called junior debt) cannot satisfy claims on the borrower's assets until the claims of the holders of senior debt are met.↩
4. Convertible bonds can convert into a specified number of shares of the issuing company at a stated conversion price. Contingent convertibles, also known as CoCo bonds, are different to regular convertible bonds in that the likelihood of the bonds converting to equity is "contingent" on a specified event. CoCos are different to existing hybrids because they are designed to convert into shares if a pre-set trigger is breached in order to provide a boost to capital levels.↩