- by GJ Prasad
You may not like it but EGG ME is here to stay
First it was the PBOC, then came the ECB and now the Fed. Investors are now starting to pencil in the likely new era of “EGG ME” or Extraordinary Globally Guaranteed Monetary Easing in perpetuity. And in this “EGG ME” background it is becoming difficult to get bullish on bank equity in any part of the developed world.
I would argue that in certain parts of the world, bank equity valuations are stretched (Canadians, Aussie and even some large cap US banks) and do not reflect economic realities. In addition, non-bank players are disrupting the traditional lenders and eating away the already shrinking revenue pie. In Europe, the problem is even more acute given that the banks have multiple fundamental problems including shrinking margins, high cost base and very poor growth prospects.
Investors getting used to GIMME
Fool me on growth, fool me on inflation but GIMME (Guaranteed Indefinite Maximum Monetary Easing) QE forever seems to the only way to keep risk assets from completely falling over. Given that decent global growth levels are getting increasingly difficult to achieve and inflation not reaching targets in any sustained manner, central bank after central bank are outplaying one another on who is going to be more dovish. And the minute there is a semblance of monetary policy normalisation, investors are throwing a big tantrum and running for the hills.
This backdrop means that monetary accommodation is likely to stay for extended periods of time or even indefinitely and that certainly seems to be the case in Europe. In addition to the above issues facing the sector, investors are focussing on:
- complexity of legal structure and intra-group lending
- cross border exposure especially in high risk EM countries
- level of potential impairment from holding periphery government bonds
- operational / reputational risks especially relating to KYC/ML
- reliance on cheap central bank funding
If you didn’t notice, European Bank Index (SX7E) was down almost 7.5% last week reflecting investors angst and despair about earnings momentum. We can add to it the Brexit related uncertainty and the very poor PMI numbers in Germany and France.
What to do in bank capital investing?
From an equity investor perspective, at first sight, valuations across the sector seem cheap given the low Price/TNAV (trading at a large discount to tangible net asset value), attractive dividend yield and fairly priced on a price to forward-looking earnings estimates. But all of the three valuation metrics could still be questioned – is TNAV accurate? Are dividend payouts sustainable? Are the forward estimates realistic?
Valuations may be cheap and attractive but markets see to be focused on the “unknowns’ and risk/issues outlined above and they are unlikely to be resolved anytime soon. Clearly qualitative factors comfortably taking precedence over quantitative models.
With bank equity looking potentially expensive and likely to underperform, investors may be forced to look into high yielding assets such as AT1s and bank sub debt. Whilst the carry on AT1s may be attractive (given where risk-free assets are trading) there are other issues to consider including risk premium, equity/rates volatility and most importantly secondary market liquidity.
The structural weakness of the European banks come to the fore when they are sliced and diced in a worst case scenario – very poor earnings profile, inadequate reserve coverage for impairments and core capital shortfall due to leverage. In such scenarios (though a low probability event), at least for some banks, capital burn is significant and whilst equity investors will take most of the hit, the AT1 instruments may yet come into play in terms of potential write-downs or conversion into equity.
This I think would be due to the issuer reaching PONV (point of nonviability) and regulator stepping in well before actual triggers come into play. This PONV is the biggest unknown qualitative factor (and one that is decided by the regulator) in AT1 valuation. Thus, single name selection becomes even more important in AT1 investing.
Devil is in the details – keep on buying does not work
One thing is for sure – this asset class needs specialist / expert handling – someone who understands the macro picture in addition to having a deep knowledge of the issuer and the sector and can handle the volatility that comes from the underlying cross-asset structural features.
Having said that there are a number of issues that look attractive to own for long- term investors. Next comes the question of liquidity, as to who would be the marginal buyer of these AT1s in size and what is the clearing level for that. I believe that AT1s yielding 7% (and above) on a yield to call basis and 6% on a yield to perpetuity basis should find some decent interest. A number of AT1s issued by large cap high quality European banks screen well on this metric including the likes of Lloyds, HSBC, UBS, ING, Nordea.
And when it gets there, I believe specialist bank capital funds, distressed debt investors and private equity firms will want to own this but as a price taker. The asset class needs a certain type of deep pocket investor with locked in capital and one who is prepared to do the necessary deep dive work both at an issuer level and at an issue level. And be able to slice and dice the balance sheet to estimate asset recovery values and its impact on capital structure.
Bank LT2, NPS and TLAC paper look attractive – significant cushion given buffers
Sub debt is always going to trade on the back of equity performance and investor perception and hence unlikely to materially tighten in spread terms but may outperform equity/AT1. In particular, the sub debt issues from the large banks in Italy and Spain are attractive to own.
Also, it appears to me that Non-preferred senior bonds issued by the larger banks and TLAC paper issued by global banks are starting to become attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.
In conclusion, there are some interesting relative value opportunities in the bank capital space and investing in it is becoming much more interesting from a relative value perspective. To some extent this strategy takes out the directional risk element. Careful single name selection and then determining which part of the capital structure to invest is clearly becoming more crucial.
Some examples include being long AT1s issued by Uncredito and short that bank’s equity. Or taking on a long NPS issued by ING Bank versus shorting ING Bank AT1s. We like being long ACAFP AT1 versus the bank’s LT2. And we would like being long UK and Nordic bank AT1s against SX7E put options. In all cases, the exact choice of issue and the trade notional ratios need to be carefully selected. For more insight and recommendations, drop us a line.