August 2020

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  • 1. We have been asked if the GAM Star Credit Opportunities funds are investing more in legacy bonds from UK banks, compared to AT1 CoCos from UK banks (given the coupon risk on AT1 CoCos).

    We do own both legacy and new-style bonds from the UK banks. In our view, there is significant value in both, for example:

    HSBC 6.375% USD AT1s callable in 2024 (coupon reset to the 5-year swap rate + 3.705% if not called) currently trades at 550 bps of spread, or 5.8% yield in USD. The bonds are rated Baa3 by Moody’s and BBB by Fitch, and therefore we are capturing high spreads for investment grade paper and see significant value

    NatWest (RBS) Legacy Perpetual floating rate notes (FRNs) (floating coupon of Libor +232 bps) in USD currently trade well below par at 95%. NatWest (RBS) can redeem those at par from December 2021 at which point the bonds will no longer count as capital. This is equivalent to a 7% yield to call (or circa 650 bps of spread)

  • 2. Performance differences between EUR and USD fund

    The key difference between the EUR and USD fund performance is that EUR-denominated subordinated debt has underperformed USD-denominated subordinated debt, even for the same issuers. Taking AT1 CoCos as an example, you can see below that EUR AT1 CoCos are down 5% year-to-date, compared to USD AT1 CoCos that are up around 2% year-to-date (7% differential).

    Obviously, the decline in rates in USD has helped USD bonds perform better, but spreads have also recovered to a larger extent in USD. Spreads on EUR AT1 CoCos are still 230 bps wider year-to-date, while only 160 bps wider on USD AT1 CoCos. In short, USD AT1s have recovered more rapidly and benefitted from the rates tailwind. Forward-looking, it means that EUR AT1s have scope to outperform USD AT1s, as it is fair to expect that over time, this spread differential should normalize.

  • 3. BBVA’s Mexican business

    BBVA has high exposure to lending in Mexico, especially in consumer lending which has been deteriorating lately due to Covid-19. We have been asked about the potential impact to our portfolios given the worsening outlook for consumer loans in Mexico.

    BBVA has significant exposure to Mexico (12% of the group’s loans), and the situation there is challenging. However, we think it is important to take into account 1) the group’s diversification and long-term track record, where the group has not made a loss (even during the global financial crisis and Eurozone crisis) and 2) the Mexican entity is highly profitable (around 900 bps margin) and therefore has the capacity to absorb potentially higher credit losses.

    With the group’s 304 bps buffer to MDA (EUR 11 billion) as well as its significant earnings buffer (EUR 13 billion pre-provision profits per annum) the group has significant capacity to absorb potential higher credit losses. Year-to-date, the group has set aside EUR 4.1 billion for loan losses, due to very harsh macro assumptions taken (Mexican GDP drop of 9% to 12% in 2020, Eurozone GDP drop of 7% to 11%).

    For BBVA, we see Covid-19 as an earnings story and not a balance sheet story as higher loan loss provisions will be absorbed by earnings, while excess capital has increased due to regulatory easing. We therefore remain very well protected and are capturing spreads of around 700bps on BBVA’s AT1 instruments.

  • 4. Investing in subordinated financials debt versus corporate hybrids

    In general, we find both subordinated financials and corporate hybrids attractive. Corporate hybrids are a good tool for us to diversify our exposures.

    Nevertheless, we find the best value in financials (European banks and insurers) given:

    • – More attractive spreads, with around 500 bps on financials versus 200-300bps on corporate hybrids. We therefore see more upside on financials where spreads are extremely wide
    • – Legacy bonds with significant optionality in subordinated financials that does not exist in corporate hybrids

    In terms of earnings, click here to read a recent article on Q2 results of banks and insurers.

    In short, fundamentals of the sector remain strong, as the Covid-19 impact is absorbed by earnings and excess capital has increased year-to-date – providing a very strong buffer for banks to protect bondholders.

  • 5. Barclays Q2 results

    Regarding Barclays, the bank reported results that were solid. Revenues benefitted from strong trading results that helped to offset the group’s GBP 1.6 billion loan loss provisions for the quarter, therefore remaining profitable despite GBP 3.7 billion of loan loss provisions for the first half of the year. Capital was the big positive surprise, with CET1 coming at 14.2% (+110 bps quarter-on-quarter) which brings excess capital to GBP 10 billion, top-tier.

  • 6. We have been asked for our view on HSBC’s Q2 results, which we regard as strong from a fixed income perspective.

    Profits were under pressure, but the group remained profitable despite a 7x surge in loan loss provisions (compared to Q2 2019) to USD 3.8 billion for the quarter. The group expects to take provisions of USD 8-13 billion, so a large portion has already been booked in the first half of the year (USD 7 billion), and this compares to pre-provision profits of above USD 20 billion for the year – very manageable, in our view. The group actually improved its capital position, with its common equity tier one (CET1) ratio up 40 bps on the quarter to 15%, which represents a USD 35 billion buffer (excess capital) to requirements. Clearly there are headwinds for the group (US-China tensions, Brexit, Covid-19), but given the group’s strong excess capital position and ability to absorb potential loan loss provisions through earnings, we see the risk as very remote from a credit perspective, and in our view HSBC remains one of the strongest European banks.

    Regarding HSBC’s bonds, the group’s AT1 CoCos remain attractive, in our view. For example the 6.375% USD AT1s callable in 2024 (coupon reset to the 5-year swap rate + 3.705% if not called) currently trades at 550 bps of spread, or 5.8% yield in USD. The bonds are rated Baa3 by Moody’s and BBB by Fitch, and therefore we are capturing high spreads for investment grade paper and see significant value.

  • 7. Regarding the funds’ exposure to UK banks, we have been asked for an assessment of these bonds against the backdrop of forthcoming Brexit negotiations with the European Union and potential ramifications on the financial marketplace?

    In terms of UK banks, our focus for us is on:

    Banks domiciled in the UK, such as HSBC and Standard Chartered, but that are extremely well diversified geographically and therefore less exposed to Brexit

    National champions like Lloyds and NatWest (previously RBS), where fundamentals are extremely strong and focused on domestic retail banking

    In both cases, these are banks with significant excess capital positions, for example NatWest (RBS) has a CET1 ratio of 17.2% which represents GBP 15 billion of headroom to maximum distributable amount (MDA).

    Although Brexit is a risk, we believe that given the very robust fundamentals of the sector and as banks have been preparing for Brexit for the past three / four years, the UK banks we own are very well positioned no matter the outcome. UK banks are subject to very stringent stress tests from regulators every year, and based on the last set of results, UK banks are able to withstand an extreme macro shock with the average CET1 ratio of the sector falling from 15% to 10%, which is more than 2x the amount of capital pre-global financial crisis.

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