Monthly Commentary October

GAM Star Credit Opportunities (EUR)

During the month of October, we saw some positive developments within the securities we invest in. Firstly, the European Banking Authority (EBA) gave its opinion on legacy bonds and the message is very clear – banks should call / redeem all their legacy hybrids to the extent possible. This is positive for the legacy space. Instruments which have been issued under Basel II and Solvency 1 (so-called legacy / grandfathered bonds) do not comply with the new regulatory framework. Over time, these bonds are becoming an inefficient source of regulatory capital for institutions. Therefore, there is a lot of positive optionality in terms of having issuers tendering or calling these bonds over the coming quarters or years at significant premiums to current prices, as we have already seen. Secondly, Rabobank announced that it will pay a scrip-dividend equivalent to 6.5% on the certificates. The price of those moved up on the news, but those have scope to increase further, in our view. Finally, Q3 earnings season has begun and, for the moment, results have been strong from a credit perspective. Loan loss provisions have decreased significantly and should be at the lower end of initial projections for the year. Most of the banks have reported higher capital ratios, as profits before provisions remain elevated. This is in line with our view that banks should be able to withstand the Covid-19 shock through pre-provision profits, as banks should generate enough income, and have built up enough excess capital to cover future expected credit losses. We do expect prices to continue to recover, given the strong fundamentals of our issuers and the attractive valuations of our securities, especially as we are still able to capture spreads of more than 550 bps. Moreover, the continuation of strong fiscal support, combined with central bank easing, should be supportive for the valuation of our securities.

GAM Star Credit Opportunities (GBP)

During the month of October, we saw some positive developments within the securities we invest in. Firstly, the European Banking Authority (EBA) gave its opinion on legacy bonds and the message is very clear – banks should call / redeem all their legacy hybrids to the extent possible. This is positive for the legacy space. Instruments which have been issued under Basel II and Solvency 1 (so-called legacy / grandfathered bonds) do not comply with the new regulatory framework. Over time, these bonds are becoming an inefficient source of regulatory capital for institutions. Therefore, there is a lot of positive optionality in terms of having issuers tendering or calling these bonds over the coming quarters or years at significant premiums to current prices, as we have already seen. Secondly, Rabobank announced that they will pay a scrip-dividend equivalent to 6.5% on the certificates. The price of those moved up on the news, but those have scope to increase further, in our view. Finally, Q3 earnings season has begun and, for the moment, results have been strong from a credit perspective. Loan loss provisions have decreased significantly and should be at the lower end of initial projections for the year. Most of the banks have reported higher capital ratios, as profits before provisions remain elevated. This is in line with our view that banks should be able to withstand the Covid-19 shock through pre-provision profits, as banks should generate enough income, and have built up enough excess capital to cover future expected credit losses. We do expect prices to continue to recover, given the strong fundamentals of our issuers and the attractive valuations of our securities, especially as we are still able to capture spreads of more than 550 bps. Moreover, the continuation of strong fiscal support, combined with central bank easing, should be supportive for the valuation of our securities.

GAM Star Credit Opportunities (USD)

During the month of October, we saw some positive developments within the securities we invest in. Firstly, the European Banking Authority (EBA) gave its opinion on legacy bonds and the message is very clear: banks should call / redeem all their legacy hybrids to the extent possible. This is positive for the legacy space. Instruments which have been issued under Basel II and Solvency 1 (so-called legacy / grandfathered bonds) do not comply with the new regulatory framework. Over time, these bonds are becoming an inefficient source of regulatory capital for institutions. Therefore, there is a lot of positive optionality in terms of having issuers tendering or calling these bonds over the coming quarters or years at significant premiums to current prices, as we have already seen. Secondly, Rabobank announced that they will pay a scrip-dividend equivalent to 6.5% on their certificates. The price of those moved up on the news, but those have scope to increase further, in our view. Finally, Q3 earnings season has begun and, for the moment, results have been strong from a credit perspective. Loan loss provisions have decreased significantly and should be at the lower end of initial projections for the year. Most of the banks have reported higher capital ratios, as profits before provisions remain elevated. This is in line with our view that banks should be able to withstand the Covid-19 shock through pre-provision profits, as banks should generate enough income, and have built up enough excess capital to cover future expected credit losses. We do expect prices to continue to recover, given the strong fundamentals of our issuers and the attractive valuations of our securities, especially as we are still able to capture spreads of more than 430bps. Moreover, the continuation of strong fiscal support, combined with central bank easing, should be supportive for the valuation of our securities.

Spotlight: Q3 2020 bank results

European banks have started to report third quarter earnings in the past few weeks. Broadly, these were ahead of expectations and positive from a credit perspective as banks continue to accumulate excess capital and loan loss provisions declined close to pre- Covid-19 levels. There are three main trends that stand out; 1) loan loss provisions have declined materially as banks have front loaded in the first half; 2) capital ratios continue to rise and excess capital positions are now well above pre-Covid-19 levels; 3) profitability momentum has started to improve and on aggregate pre-provision profits of the sector has been more than sufficient to absorb higher credit losses.

UBS

UBS published strong Q3 2020 results, benefitting from strong corporate and investment banking (CIB) performance and the sale of the group’s stake in Fondcenter AG (one-off). With a return on common equity tier one (RoCET1) of 21.9% and a CET1 ratio up 20 bps quarter-on-quarter to 13.5%, the group ticked all the right boxes, in our view, paving the way to pay the second part of the annual dividend, and making a reserve for a potential USD 1.5 billion share buy-back. We believe the results reflect the group’s resilient business model focused on recurring fee income in wealth and asset management with limited impact from Covid-19.

UBS’ profitability was strong in Q3 2020. Profits before tax were up 41% year-on-year to USD 2.1 billion. Wealth management results were resilient with a rise in assets under management and higher transaction income. Retail banking continues to be under pressure from low rates and a lower volume of retail transactions (credit card payments, etc). CIB was the clear outperformer on the quarter, as the bank benefitted from strong revenues both in global markets – fixed income, currency and commodity (FICC) revenues up 41% year-on-year) and global banking (capital markets) revenues up 87%. The group posted a strong RoCET1 of 21.9% for the quarter.

The bank’s CET1 ratio increased by 20 bps on the quarter to 13.5%, with a 380 bps buffer to minimum requirements (USD 11 billion buffer). Risk-weighted assets (RWA) declined on the 1.2% quarter-on-quarter and CET1 also slightly down due to the USD 1.5 billion share buy-back accrual (already deducted from CET1). Adding back the share buy-back, CET1 would be up 70 bps to 14%, providing an additional buffer in case of increased uncertainty.

On asset quality, loan loss provisions were USD 89 million for the quarter, mainly driven by a single exposure (USD 59 million) which is a well-known trade finance case, otherwise close to normalised levels. These were sharply down versus Q2 (USD 272 million) but remained above Q3 2019 (USD 38 million). The group’s lending book is very robust, mainly low loan-to-value (LTV) Swiss mortgages and loans to wealthy customers secured by assets – reflected in a non-performing loan (NPL) ratio of 0.5% of loans to customers (stable quarter-on-quarter).

HSBC

HSBC reported strong results, beating consensus figures on earnings, with credit losses declining significantly compared to H1 2020 and now expected to be at the lower end of management guidance (USD 8-13 billion) for FY 2020 and a solid CET1 ratio of 15.6%.

On the earnings side, there was continued pressure on revenues, which fell around -10% year-on-year to USD 12.1 billion. This is mainly due to the group’s net interest margin (NIM) falling around 13 bps quarter-on-quarter (-36 bps year-on-year) due to ongoing pressure from low rates (especially in Hong Kong). This was offset by strong results in CIB (revenues +15% year-on-year). The group continues to reduce expenses, which were down 3% year-on-year to USD 7.4 billion due to cost saving programmes. Loan loss provisions were USD 0.8 billion in Q3, down 80% compared to USD 4 billion in Q2. Despite Covid-19 uncertainty and elevated loan loss provisions in H1 2020, the group generated a return on equity of circa 5% for the first nine months of 2020, reflecting the resilience of the business model.

On capital, the group’s CET1 ratio increased by around 60 bps on the quarter to 15.6%, due to retained earnings and reduced headwinds on RWA. Excess capital is up another circa USD 5 billion on the quarter to a massive USD 40 billion to protect bondholders. The bank’s leverage ratio unchanged at 5.4%. The group continues to de-risk certain areas with RWA down USD 12 billion on the quarter, excluding FX.

On asset quality, loan loss provisions for the quarter were at USD 0.8 billion (30 bps of loans) compared to USD 4 billion in Q2, sharply down as the bank front-loaded the expected impact. Management now guides to loan loss provisions at the lower end of the USD 8-13 billion range, versus USD 7.6 billion for the first nine months of 2020. Despite Covid-19 uncertainty, HSBC has high capacity to absorb loan loss provisions, with circa USD 22 billion of pre-provisions profits compared to USD 7.6 billion of loan loss provisions in the first nine months of 2020, therefore provisions would need to triple to wipe out the group’s earnings buffer.

Barclays

Barclays posted a strong set of results in Q3, with strong CIB performance and significantly lower provisions alleviating other revenue headwinds in retail banking. Capital remains strong with a CET1 ratio coming in at 14.6% and buffer to maximum distributable amount (MDA) up another 30 bps quarter-on-quarter and 120 bps year-on-year.

Earnings momentum remains solid, despite Covid-19 uncertainty as the group posted return on tangible equity (RoTE) of 5.5% for the quarter. Profits before tax were down 33% year-on-year, but up sharply versus Q2 2020. Revenues were down 6% year-on-year, mainly due to rates pressure in UK retail banking, as well as lower activity in cards and payments. CIB continued to perform strongly in Q3, driven by global markets where FICC revenues were up 31%, equities (+50%). Costs were up 3% year-on-year due to Covid-19 headwinds, nevertheless the group’s cost efficiency remains sound with a cost to income ratio of 65%. Loan loss provisions were GBP 608 million, up 32% year-on-year and down 63% versus Q2 2020.

Barclays continued to accumulate capital as the group’s CET1 ratio was up 40 bps quarter-on-quarter to 14.6%, due to retained earnings and lower RWA headwinds (down on the quarter due to regulatory easing and client activity). The banks’ MDA buffer rose to 330 bps, equivalent to GBP 10.3 billion of excess capital.

Asset quality trends have been supportive in Q3 as GBP 0.6 billion provision for Q3 2020 compares favourably to Q1 / Q2 (GBP 2.1 and GBP 1.6 billion), at 69 bps annualised (as % of loans), which is starting to look “normal”. The increase compared to Q3 2019 was mainly due to specific single names in CIB, as well Covid-19 updates. Total non-performing loans declined by 3% quarter-on-quarter to GBP 8.9 billion, and with a 2.5% NPL ratio, the quality of the book remains strong. Total provisions of GBP 8.7 billion equates to 98% coverage, which is robust. Payment holiday balances have declined sharply, for example GBP 4.4 billion on UK mortgages versus GBP 15 billion in June (only 3% of book), 1% on cards and only 4% on UK personal loans.

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