By Satish Pulle
With sovereigns taking centre stage once more on the back of the Italian elections, given the strong link to the European banking sector we thought it might help to offer our current outlook for the financial sector. What major changes to the financial credit landscape are likely over the next decade? Below are some major developments we foresee.
Coco issuance: As more regulators accept the coco structure, we expect substantial issuance of both equity conversion and write-off structures. We hope to see write-off structures limited to the low trigger cocos, and equity conversion for high-trigger cocos. We feel this mix better aligns incentives of equity investors, management, coco holders and regulators. In terms of volume, while cocos got off to a slow start we would not be surprised to see €100bn of coco issuance over the next five years.
Tier 2 Subordinated debt, with substitution and variation language: We expect more issuance of Tier 2 with such language included, as Basel III implementation is pushed to a January 2014 start date. Tier 2 issuance in 2012 was about €20bn.
Basel III compliant Tier 1 issuance: The so-called Additional Tier 1 structure as currently envisaged under Basel III still has elements which make them junior to equity, for example coupons can be cancelled without switching off dividends. As such, we would remain very sceptical of these structures, unless the final versions of the Capital Requirements Directive IV (CRD IV) introduce needed changes.
Government stake reductions via cocos: Governments across Europe own stakes in their banks. As the Bank of Ireland deal has paved the way, other governments may look at converting their stakes into cocos and selling the cocos to private sector investors. For instance, this could happen with RBS, and perhaps in 18-24 months with the Spanish banks.
Structural changes still to come: Unless returns on equity (RoEs) on retail, commercial and investment banking businesses start to grow again in 2013-14, we would expect equity investors to tire of current low RoEs, and start demanding fundamental changes to banking business models. Likely structural changes could include sharp cutbacks in balance sheet size and risks to release trapped equity, sale of non-core businesses, etc.
Ratings – where bad news can be good news: Looking at the Merrill Lynch European investment grade subordinated financials index (EBSU), the “composite rating” for the index has come down from A1 in 2007-8 to BBB1 currently. Current low ratings for subordinated bonds and expected potential for further downgrades constrain both investment grade bond funds and insurance companies from investing in the sector. Counter- intuitively, all this negative rating development is good for bond investors, because it leads to a better appreciation of the risks involved, and more attractive yields.
Eventual rate rises: At some point over the next three years, government bond yields are likely to rise from their current extremely low levels. This bodes well for high yield subordinated financials bonds which are less exposed to a rise in government bond yields, compared to “spread” bonds which have low total yields. Also, future refinancing of cocos in the 2018- 2021 period will likely be at attractive total yields if government bond yields have risen by then.
Satish Pulle is lead portfolio manager at ECM Asset Management
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