More resilient bank bonds

But not all is equal

03 July 2020

7 minute read

By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy

Predicting loss provisions amid COVID-19 is not an easy job for banks. But higher capital ratios, a more conservative risk management approach and strict regulations suggests that the banking sector is more resilient than before.

Trapped bond yields

Bond investors are rightly concerned about low yields and the threat of yields trending higher. Rarely has this been more justified than now.

The fear of record government debt piles (over $4.5tn is expected in the US this year) and the prospect that central banks will need to reduce the amount of sovereign debt on the balance sheet (which seems likely to increase towards $10tn by year end). However, for now we believe that disinflationary tendencies and aggressive central bank policy globally will keep rates lower.

While potential news of a vaccine could lead to a sharp rise in yields, it remains to be seen whether an economic recovery will make good the lost ground and quickly lift inflation beyond central banks’ inflation targets.

Meanwhile, yields of investment grade bonds have reversed sharply as spreads pulled back remarkably from the 400 basis points (bp) above treasury yields seen in March. The tightening move was recently accelerated by the US Federal Reserve’s decision to start buying single-line corporate bonds through its Secondary Market Corporate Credit Facility.

The financial sector

In our last edition we focused on the BBB-rated pool of the investment grade bond market. This time we take a closer look at the financial sector. This is by far the largest sector across various markets, with roughly a 40% market share in corporate investment grade debt (by value).

Our conclusion is that banks look much more resilient than was the case in 2008, so any parallels between the credit crisis and now largely do not apply. However, there may be potential distress in the sector. So a closer look at the main drivers of such distress is warranted.

Will realised losses exceed earmarked losses?

First-quarter earnings numbers have declined sharply for many banks around the world, even leading to losses for a minority. The profit decline was largely caused by loan loss provisions. But the almost impossible task of estimating impairments is reflected in the large dispersion of provisions reported by banks. For instance, European banks posted provisions ranging from around 30bp of outstanding loans up to 250bp. In the US, provisioning in the first three months of the year alone was already ranging from around 80% to 250% of the full 2019 provisioning.

Banks must also consider the quality of the loan book. In Europe, non-performing loans are the lowest seen since 2007 (2.3%) so far. However, non-performing loans are likely to increase substantially and vary from bank to bank. The biggest sensitivity will be around the small and medium enterprise (SME) loan book and non-secured consumer financing.

While depressed yields are likely to weigh on net interest margin, this time it is likely to be the US banks that need to adapt. Overall, a drop in earnings by around 50% on average can be expected this year. But as discussed the dispersion between banks’ earnings should be wide. On the positive side, earnings from capital markets are likely to rise for some banks, due to increased volatility and trading as well as a substantial rise of syndication fees on the back of record bond issuance.

Equity ratios with ample cushion

Core equity tier 1 capital ratios (CET 1) ratios are expected to fall as risk weighted assets (RWA) will increase substantially. This is due to larger “revolver loan” commitments as well as an increase in corporate loans. Meanwhile, state guarantees given to troubled sectors should lead to some RWA relief for banks in the coming quarters.

It will be difficult to assess the magnitude of RWA inflation overall. The latest Bank of England stress tests for UK banks (including COVID-19 assumptions) for example model for a 33% increase in RWA over the next two years. But even with this increase, regulatory buffer requirements would be met by most, given the comfortable capital ratio levels banks maintain nowadays.

In the US the latest COVID-19 stress test, conducted by the Fed, attested ample capital buffers for most of the US banks even under a more severe scenario. The quality of bank balance sheet differs, but high capital ratios and a generally more conservative approach to risk management makes the sector appear more resilient, in our view.

High capital ratios and a generally more conservative approach to risk management makes the [banking] sector appear more resilient, in our view

Are bank bonds fallen angel candidates?

Firstly, it depends on the quality of the bank and secondly it depends on the debt instrument of the respective bank. Since the credit crisis of 2007-2008, a major overhaul by the regulators globally led to various types of bank bonds issued. The bonds aim to help make potential bank resolution easier, and to avoid using taxpayer money for potential bailouts.

While senior preferred bonds are mostly pari-passu to the most senior unsecured debt (deposits and counterparty transactions) in a bank balance sheets, senior non-preferred or Tier 2 bonds are subordinated and are bail-in-able if needed. The same is true for the most junior, part additional Tier 1 bank bonds, which usually are rated as high yield by most banks.

Not all bonds are equal

Bond ratings reflect the risk various bond rankings of one issuer carry. For a single A rated bank, this could mean that respective senior non preferred or Tier 2 bonds are rated in the BBB space and therefore at risk of falling into “junk” status should the company’s A rating be downgraded.

While we are constructive on bank bonds, the diverse nature of the sector, reflected by the quality and types of bonds used by different issuers, suggests that thorough selection is needed in order to capture attractive opportunities.

Typical hierarchy of bank debt
  Typical bank debt format Rating example bank (Moody's methodology) Comments
Non-guaranteed deposits/counterparty contracts Aa3 Any household or corporate deposits (not guaranteed by a deposit scheme) or derivatives contract a bank may have with other financial counterparties.
Senior preferred debt Aa3 Senior unsecured debt in the format of loans or bonds which can be most compared to the conventional senior bonds seen in the past.
Bail-in able debt/total loss absorbing capital (TLAC) Non-preferred senior debt (NPS) Baa1 Debt which in general is senior but in a bank resolution situation forms part of the resolution mass and supports the debt ranked above. Capital will only be “bailed in” after any subordinated debt has been used. Like with senior preferred debt coupons must be paid. Typical format in Europe. In the UK this format can be seen as senior bonds issued out of the respective holding entity (HoldCo bonds).
Subordinated debt (eg Tier 2) Baa2/Baa3 Similar to NPS but subordinated to any senior debt in a liquidation and resolution situation. Older formats can have a capital write down trigger while newer formats do not have such a trigger. Can be callable or bullet bonds. Coupons are guaranteed (gone concern principle).
Junior subordinated (eg AT1 /preferred shares Ba1 Most junior part within the debt hierarchy. AT1 debt is issued as going concern capital which means that coupons may be cancelled or reduced if capital and profit requirement are not met and capital can be written off or converted to equities if needed. Such events would not necessarily constitute default.
Community equity tier 1 (CET 1)   Banks need to hold a minimum amount of CET 1 capital under bank capital adequacy requirements.

Market Perspectives July 2020

Financial markets have had a very strong second quarter, despite geopolitical tensions and fresh outbreaks of COVID-19 in US and German states and in Beijing.


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