The recent European bank earnings season has continued the positive trend of delivering better-than-expected results and higher capital ratios. This further supports our constructive outlook for the AT1 market.
Fundamentals
For credit investors, the strength of a company’s balance sheet is crucial. Since the Great Financial Crisis, banks have significantly improved their capital positions and this quarter saw a continuation of that trend despite concerns related to the COVID-19 pandemic, highlighting the resilience of the sector. Reported earnings were better than expected, driven by higher revenues and lower provisions. Common Equity Tier 1 (CET1) ratios – a key indicator of the strength of banks’ balance sheets and one closely monitored by credit investors – increased by around 0.3% to 13.7%, putting them at more than double their pre-crisis levels and significantly above current AT1 Trigger levels. In addition, regulatory actions and government relief measures should act as a further shock absorber for banks. Capital requirement relief, specifically through the removal or reduction of the countercyclical buffer and cancellation of dividend payments, further strengthen the fundamental argument for AT1s; however, it should be noted that this is not the case for AT1 coupons, as Andrea Enria, Chair of the Supervisory Board of the ECB, stated,
“Payments on Additional Tier 1 and Tier 2 instruments are standard payments on debt and hybrid instruments as they come due. In my view, suspension of these payments should be triggered only if and when the maximum distributable amount, the triggers set in the European legislation, are hit. So we have no plans to take any action on Additional Tier 1 and Tier 2 payments.”
Macro
Recent news reporting efficacy rates of over 90% of two potential COVID-19 vaccines is significant and increases confidence in 2021’s growth recovery. Any growth-restrictive measures implemented by governments to contain the virus ahead of the distribution of the vaccine will now be seen as a temporary blip, rather than anything more sustained or permanent. Despite these positive developments, central bank support is set to remain in place, with recent comments from both the ECB’s President Lagarde and the Fed’s Chairman Powell focusing on the short-term downside growth risks from rising infections, rather than on the medium-term benefits of an effective vaccine. This outlook will probably lead banks to factor in lower losses in 2021 than 2020, and should also help limit any detrimental impact on NPLs due to the COVID-19 crisis. This will boost hopes that the recent trend of positive earnings surprises can continue.
Valuations
Strong fundamentals and an improving growth outlook, coupled with less event risk now that the US elections are over, dovish central banks and vaccine progress will probably lead investors to search for yield and for credit spread compression to play out. Whereas higher-quality, fixed-income asset classes, such investment-grade credit, have seen spreads compress to pre-COVID levels, this is not the case for the AT1 market. Should AT1 spreads narrow as we expect, this would lead to capital gains for investors in the asset class.
Looking ahead, we believe exposure to AT1s should put investors in a good position for the global recovery in growth that is set to take place in 2021.
Philippe Gräub
Head of Global & Absolute Return Fixed Income
Bernard McGrath
Investment Specialist