28th February 2019

No Stopping the Easy Carry Business (ECB) | Bank Capital Insights

Carry on TLTRO – The show must go on

It seems that market participants are placing more and more confidence that the ECB will announce a new fixed TLTRO program next month. That will mean credit supply to the EZ economies will continue unabated and counter any economic slowdown, with the biggest beneficiaries of the new program likely to be the peripheral banks, especially the Italians.  Credit investors are now getting used to the never-ending easy monetary policy accommodation and getting forced to move into riskier parts of the capital structure.

If the ECB does announce a large new fixed TLTRO and take up is decent, potential funding issues for a number of banks will be taken care of and potentially ease financing conditions.  But it is not clear if the new TLTRO will help the banks overcome the chronic low earnings problem given the margin pressure and high cost base.

The new potential TLTRO is likely to cause a further drop in issuance of unsecured bonds from the banks and lead to further tightening of senior unsecured bond spreads.  To that extent, subordinated debt issued by the EZ national champion banks (especially the Spanish and Italian banks) look attractive. As far as AT1 is concerned, it is more nuanced and careful single name selection is required to reflect a number of factors including supply (to refinance calls), back end resets, duration and tail risks.

AT1 the star performer in the Land of Carry

AT1 bonds have generically rallied 4-5 points or so this year but some bonds are up 6-8 points in a very short period and translating to a 5+% return.  All this in the first 2 months of this year and half the returns (10%) I had projected in this for the entire year.

In a nutshell, the performance was driven by re-assessment of rates, rally in risk assets, a drop in volatility, better than expected earnings, and mouth-watering yields on USD paper issued by fundamentally strong names.  Add to that the old chestnut of a lack of supply coupled with cash that folks had to put to work – leading to inevitable short covering.

And I don’t see any reason why it would not hold for now.  However, it’s clear that single name selection becomes key and owning the right instrument becomes even more crucial.   Owing AT1s issued by high-quality issuers like HSBC, ING, Lloyds, Nordea, Rabobank and UBS should provide safety until all clear signals emerge.

Will the show continue?

The answer seems to be: Why not, as long as easy money is around.  Just like the recent warm few days at the end of February, the risk-off season seems to have taken a break.  And there are few issues that have not been resolved as yet – Brexit, trade war resolution, growth slowdown, disinflation and financial conditions tightening etc.

Given this background, further significant upside performance on a directional basis seems unlikely and hence it seems setting up relative value trades is the better strategy.  I would recommend long AT1s in the defensive names which can hold up well and short the names which are exposed to many of the tail risks out there.

Carry is king when you have ECB on your side

At the end of the day, getting 6% plus carry seems too tempting (and difficult to ignore) for many,  given the potentially everlasting/never-ending easy money in Europe.  As the saying goes, ‘The road in Credit is filled with Carry.’   For now, enjoy the carry, thank the ECB and put the bear to sleep.

GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.