Monthly Commentary May

GAM Star Credit Opportunities (EUR)

During the month of May, financial markets showed some positive momentum, due to the fact that economies have been starting to gradually open, as well as the EU coronavirus recovery plan. The European Banking Authority and the Bank of England both published reports on banks. In each case, they believe that banks started this crisis with extremely high levels of capital and should be able to withstand the shock through pre-provisioned income, as banks should likely generate enough income to cover future expected credit losses, in addition to the excess capital they have built up. This is in line with our view that the Covid-19 crisis remains an equity story for European financials, and not a balance sheet story. The end of Q1 earnings went in a similar direction.

We do expect prices to continue to recover in the next six to nine months, as the uncertainty caused by the Covid-19 outbreak slowly fades away.

Despite the partial recovery, we feel current valuations remain extremely attractive, as we are able to capture spreads of more than 650 bps. On top of that, a large number of the subordinated debt of financials are still trading to perpetuity – with a large upside for bondholders on a re-pricing to call. Moreover, the fund is capturing high and predictable income.

Spotlight: Lloyds not calling one of their AT1 Coco Outstanding.

Lloyds has announced it would not be calling its 6.375% EUR additional tier one contingent capital bonds (AT1 CoCo) callable later in June (not owned by the funds), citing capital conservation as the key reason. While the group’s AT1 stack is sufficient to cover requirements (2.8% or 2.4% pro-forma for the call, versus the approximately 2.4% requirement), this is likely driven by regulatory pressure to maintain strong capital ratios, as well as the inability to refinance at more attractive levels.

Although the market had priced in some extension risk, with bonds trading at approximately 97% ahead of the call, the price dropped by two points to approximately 95% after the announcement of the non-call. This reflects the full re-pricing, as the bond is only callable every five years (next call in 2025), and new coupon, which is lower at around 5%. Also note that the fall in price of the bond was not drastic given (1) markets pricing in extension risk to a relatively high degree and (2) relatively elevated reset spread at 529 bps, which equal to a new coupon of 5.29% above 5-year swap rates. In our view, these still remain attractive for an investment grade name like Lloyds.

In the current times, issuers not calling AT1 CoCos should not come as a surprise, given the need for banks to preserve their capital base to support the real economy. We believe this should have limited read-through for the asset class in general, as spreads are currently extremely wide at 650 bps on average on EUR AT1 CoCos, and therefore do not reflect more normalised market conditions to refinance bonds.

For investors, careful consideration of the bond structure is very important to mitigate extension risk. In this case, as the bond is only callable every five years if not called, the impact of the non-call is greater than compared to other structures where the issuer has the ability to redeem bonds more frequently, which is one of the reasons we did not own it. In case of an instrument callable annually, for example, the bonds would likely reprice to the next call date (or the one after), as the likelihood of the issuer being able to refinance until then is extremely elevated. As a reminder, when Banco Santander elected not to call its AT1 CoCo back in February 2019, the bonds only fell marginally given the issuers’ ability to redeem the bonds on a quarterly basis. These were subsequently redeemed 12 months later, as Santander was able to refinance the bonds at a more attractive level – and hence extension risk was limited.

GAM Star Credit Opportunities (GBP)

During the month of May, financial markets showed some positive momentum, due to the fact that economies have been starting to gradually open, as well as the EU coronavirus recovery plan. The European Banking Authority and the Bank of England both published reports on banks. In each case, they believe that banks started this crisis with extremely high levels of capital and should be able to withstand the shock through pre-provisioned income, as banks should likely generate enough income to cover future expected credit losses, in addition to the excess capital they have built up. This is in line with our view that the Covid-19 Crisis remains an equity story for European financials, and not a balance sheet story. The end of Q1 earnings also went in that direction.

We do expect prices to continue to recover in the next six to nine months as the uncertainty raised by the Covid-19 outbreak slowly fades away.

Despite the partial recovery, we feel current valuations remain extremely attractive as we are able to capture spreads of more than 650 bps. On top of that, a large number of the subordinated debt of financials are still trading to perpetuity – with a large upside for bondholders on a re-pricing to call. Moreover, the fund is capturing high and predictable income.

Spotlight: Lloyds not calling one of their AT1 Coco Outstanding.

Lloyds has announced it would not be calling its 6.375% EUR AT1 CoCo callable later in June (not owned by the funds), citing capital conservation as the key reason. While the group’s AT1 stack is sufficient to cover requirements (2.8% or 2.4% pro-forma for the call, vs. the c2.4% requirement), this is likely driven by regulatory pressure to maintain strong capital ratios as well as the inability to refinance at more attractive levels.

Although the market had priced in some extension risk with bonds trading at c97% ahead of the call, the price dropped by 2 points to c95% after the announcement of the non-call. This reflects the full re-pricing as the bond is only callable every five years (next call in 2025), and new coupon which is lower at c5%. Also note that the fall in price of the bond was not drastic given (1) markets pricing in extension risk to a relatively high degree and (2) relatively elevated reset spread at 529bps, which equal to a new coupon of 5.29% above 5year swap rates which in our view still remain attractive for an investment grade name like Lloyds .

In the current times, issuers not calling AT1 CoCos should not come as a surprise, given the need for banks to preserve their capital base to support the real economy. This should have limited read-through for the asset class in general as spreads are currently extremely wide at 650bps on average on EUR AT1 CoCos and therefore do not reflect more normalized market conditions to refinance bonds.

For investors, careful consideration of the bond structure is very important to mitigate extension risk. In this case, as the bond is only callable every five years if not called, the impact of the non-call is greater than compared to other structures where the issuer has the ability to redeem bonds more frequently, which is one of the reasons we didn’t own it. In case of an instrument callable annually for example, the bonds would likely reprice to the next call date (or the one after) as the likelihood of the issuer being able to refinance until then is extremely elevated. As a reminder, when Banco Santander elected not to call its AT1 CoCo back in February 2019, the bonds only fell marginally given the issuers’ ability to redeem the bonds on a quarterly basis. These were subsequently redeemed 12 months later, as Santander was able to refinance the bonds at a more attractive level – and hence extension risk was limited.

GAM Star Credit Opportunities (USD)

During the month of May, financial markets showed some positive momentum, due to the fact that economies have been starting to gradually open, as well as the EU coronavirus recovery plan. The European Banking Authority and the Bank of England both published reports on banks. In each case, they believe that banks started this crisis with extremely high levels of capital and should be able to withstand the shock through pre-provisioned income, as banks should likely generate enough income to cover future expected credit losses, in addition to the excess capital they have built up. This is in line with our view that the Covid-19 crisis remains an equity story for European financials, and not a balance sheet story. The end of Q1 earnings went in a similar direction.

We do expect prices to continue to recover in the next six to nine months as the uncertainty raised by the Covid-19 outbreak slowly fades away.

Despite the partial recovery, we feel current valuations remain extremely attractive, as we are able to capture spreads of more than 500 bps. On top of that, a large number of the subordinated debt of financials are still trading to perpetuity – with a large upside for bondholders on a re-pricing to call. Moreover, the fund is capturing high and predictable income.

Spotlight: Lloyds not calling one of their AT1 Coco Outstanding.

Lloyds has announced it would not be calling its 6.375% EUR AT1 CoCo callable later in June (not owned by the funds), citing capital conservation as the key reason. While the group’s AT1 stack is sufficient to cover requirements (2.8% or 2.4% pro-forma for the call, vs. the c2.4% requirement), this is likely driven by regulatory pressure to maintain strong capital ratios as well as the inability to refinance at more attractive levels.

Although the market had priced in some extension risk with bonds trading at c97% ahead of the call, the price dropped by 2 points to c95% after the announcement of the non-call. This reflects the full re-pricing as the bond is only callable every five years (next call in 2025), and new coupon which is lower at c5%. Also note that the fall in price of the bond was not drastic given (1) markets pricing in extension risk to a relatively high degree and (2) relatively elevated reset spread at 529bps, which equal to a new coupon of 5.29% above 5year swap rates which in our view still remain attractive for an investment grade name like Lloyds .

In the current times, issuers not calling AT1 CoCos should not come as a surprise, given the need for banks to preserve their capital base to support the real economy. This should have limited read-through for the asset class in general as spreads are currently extremely wide at 650bps on average on EUR AT1 CoCos and therefore do not reflect more normalized market conditions to refinance bonds.

For investors, careful consideration of the bond structure is very important to mitigate extension risk. In this case, as the bond is only callable every five years if not called, the impact of the non-call is greater than compared to other structures where the issuer has the ability to redeem bonds more frequently, which is one of the reasons we didn’t own it. In case of an instrument callable annually for example, the bonds would likely reprice to the next call date (or the one after) as the likelihood of the issuer being able to refinance until then is extremely elevated. As a reminder, when Banco Santander elected not to call its AT1 CoCo back in February 2019, the bonds only fell marginally given the issuers’ ability to redeem the bonds on a quarterly basis. These were subsequently redeemed 12 months later, as Santander was able to refinance the bonds at a more attractive level – and hence extension risk was limited.

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