December 2019

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  • 1. Clients would like two examples of legacy bonds issued from banks for which we are capturing strong capital gains from the repricing to the loss of eligibility for capital requirements

    Context: As we have been mentioning that we are experiencing strong capital gains from loss of eligibility and repricing to regulatory call, clients would like two examples (one in Eur and one in USD) of grandfathered bonds from banks

    Impact for the fund:Strong potential for further capital gains from regulatory call as these securities arelosing their capital eligibility under new regulatory regime and up to last year have been trading at high discount and can only be redeemed at 100.



    ING (NL0000113587)

    RBS (US780097AU54).

    Both these securities are reported as becoming ineligible post-2021 and as expected RBS announced the regulatory call at par for the above ISINs.

    The grandfathering of these securities started in 2013. However, regarding undated floating rate notes, the market only started accounting for the potential Liability management exercises (LME) post-2016. LME’s can be tender offers or calls at par. Moreover, we are getting closer to the end of the grandfathering period, and we therefore believe there is a lot of optionality regarding LMEs. For banks, this has been reflected by the recent calls of Banco Santander (the bonds were trading at 67% prior to the call at par) and Commerzbank (the bonds were trading at 95% prior to the call). In 2018, potential LMEs were not priced anymore. We do not expect to see this in the future. Due to the end of the grandfathering period, we expect to see more upside within these securities.

    Banks have been giving indications on how they believed their legacy securities would be considered post the grandfathering period. Those can be found within their Pillar 3 disclosures and have been published since a number of years. Those publications were done in accordance with the regulators, however there has not been any harmonization regarding these reports. The European Banking Authority will provide clarity on the treatment of these securities within the middle of 2020. We expect this to accelerate LME’s and therefore see significant upside going forward.

  • 2. Clients are asking details on the two positions we hold in Rabobank, how have them been performing and what’s our view on the new AT1 coco vs the old Certificate?

    Context: Tighter spreads YTD masks “hidden” opportunities across the capital structure, a practical example on Rabobank

    Impact for the fund:Diversify across the capital structure aloud to capture interesting opportunities with high potential for strong performances from technical and valuation standpoint


    We have been mentioning that current valuation levels are very attractive and we have been referring to the AT1 Cocos index to assess the valuation of the financial subordinated debt, despite this very interesting opportunities can be found along the capital structure, looking more in the specific to two examples from the same Issuer, Rabobank 4.625% (AT1 Cocos) and Rabobank 6.5% (Tier1)


    Rabo 4.625% (AT1 Cocos) is trading at ca. 320bps, so the Rabobank 6.5% (Tier1) is indeed really cheap at over 501bps (if the certificates were too tightening to 450bps, all else being equal the cash price would go from 127 to 141).

    The Rabobank 6.5% (Tier1) only really performed because of the rates down-movement, and not really because of spread tightening.

    This makes this security extremely cheap and very attractive.
    Moreover, it gives close to 7.5% income when hedged back to USD. Therefore, we believe the Rabobank 6.5% are extremely cheap.

  • 3. Clients asking a view of what to expect in the year to come based on what we experienced last year

    Context: What to expect in 2020 (analysis conducted for USD fund, but same rational to apply to GBP and EUR fund)

    Impact for the fund:Positive for the year with a base case for the USD fund of +9%, EUR fund of +8% and GBP fund of +9%

    What to expect in 2020:

    To understand what might happen in 2020, one has to look back at 2018-2019. Due to external shocks and starting from 1Q18 onwards, price of bonds held in the portfolio started to drop and ended in 2018 on average 14% lower (fund was down 8% during the year, having captured close to 6% income). Since that the price drop had not been driven by idiosyncratic events or credit deterioration from issuers held in the portfolio (by contrary, average rating year-on-year went up on notch higher to BBB+), we knew that 2019 would be a year of price recovery + income. We also mentioned that in theory, performance for the year could be +22% (price of the bonds had dropped 14% and due to the so-called pull-to-par, they would need to recover +16% to be break-even, then adding the 6% income = 22%) but that given political uncertainties related to Brexit and especially trade-war, our base case for the year would instead be “only” +12%. The fund outperformed this base case by 4% as we didn’t anticipate central banks to turn as dovish as they did during 2019.

    It also means that despite the strong performance in 2019, price of the bonds that we own still trade at ca. 6% discount to where they should be trading at….

    As we enter 2020, macro backdrop is very supportive. Central banks are highly accommodative/with a dovish bias, global growth has scope to start to surprise again to the upside/led by a cyclical recovery and interest rates have scope to remain low for longer. What it means for fixed income investors: a very supportive backdrop and 2020 has scope to look like 2017, or a vintage year for bond investors (fund was up 12.6%).


    2020 Performance outlook

    Base case for the USD fund of +9%

    Base case for the EUR fund of +8%

    Base case for the GBP fund of +9%


    We feel that this is once again a conservative base case, as assuming ca. 2/3 of the performance stemming from income (5.5% gross contribution for USD fund & 4.5% for EUR fund) and only 1/3 stemming from capital gains (3.5% gross contribution). Given the supportive backdrop – contribution from capital gains could easily be 6% instead of 3.5%.

    Furthermore, the USD fund has 35% exposure to grandfathered bonds i.e. bonds that have been issued for regulatory purposes under Solvency 1/Basel II and that don’t fully comply with new capital requirements set by Solvency 2/Basel III. In a nutshell, very expensive/inefficient bonds for issuers, but extraordinary investment opportunities for investors. For example, almost half of the grandfathered bonds that we own in the fund trade at an average price of 77%. As these will be tendered at a higher price or called at par, these should over the coming quarters generate close to 4% additional capital gains for the fund.

  • 4. Clients asking some details on the results of the UK Stress Tests

    Context: The Bank of England released the results of their annual stress test exercise for UK Banks.

    Impact for the fund:The results revealed that UK banks are robust and capable of withstanding a severe stress (much worst than a disorderly Brexit) and rock solid capital levels have increased the overall resilience of the financial system.


    Bank of England Stress Test

    The Bank of England released the results of their annual stress test exercise earlier this month. Overall the results revealed that UK banks are robust and capable of withstanding a severe stress and rock solid capital levels have increased the overall resilience of the financial system. All banks passed the stress test, and no bank needs to take remedial action. On Aggregate banks’ core equity ratios (CET1 ratio) would fall by 520bps to 9.3% under the stress scenario, well above the hurdle rate of 7.5%, with no banks’ individual capital positions falling below 8.5%.


    The stress scenario used by the Bank of England, is designed to simulate a true “apocalypse” scenario. This is indeed more severe than the global financial crisis, with for example world GDP declining by 2.6pp (1.2pp during the financial crisis) or residential property prices declining by 33% (17% during the financial crisis). At 9.3% CET1 ratio at the low point of the stress scenario, UK banks would still have more than twice the amount of equity buffer than in 2007. This reflects the strong capital accumulation (CET1 ratio c3x higher than pre-GFC) as well as the strong de-risking of banks’ business models towards low-risk activities such as retail mortgages. As bondholders this is highly positive as there is a higher amount of equity buffer to absorb losses that would be significantly lower than that experienced during the GFC.



    In the face of geopolitical uncertainty (Trade wars, Brexit etc.), bondholders can take great comfort from the very strong performance of banks in the stress test. Nevertheless, it is paramount to keep in mind that the stress test is designed to reflect an unprecedented extreme stress scenario. In particular, there have been some amalgamation between the stress test and Brexit – where in our view even a disorderly hard Brexit impact would be nowhere near the stress test impact. Fortunately the Bank of England, that has previously been vocal about the fact that the stress test is in no way designed to reflect a Brexit scenario, has disclosed an estimated impact of a disorderly Brexit. While the stress test impact is above 500bps of capital drawdown, the Brexit scenario leads to c200bps of capital drawdown – significantly lower impact. Under the disorderly Brexit scenario the average CET1 ratio of banks would remain well above 12%, very strong.



    For UK issuers held in our Fund – mostly the UK-domiciled global banks (HSBC, Standard Chartered) and national champions (Lloyds, RBS, etc.) the results of the stress test support our positive view of the European financials sector underpinned by ever-stricter regulation. Banks have significantly increased their capital positions and de-risked their business models – leading to higher capacity to absorb losses and lower potential losses in a stress. Furthermore, any impact from current geopolitical issues such as Brexit are highly manageable for our issuers, even in a tail risk scenario (not our base case). We have strong visibility on the future path of capital accumulation over the coming decade – with Basel IV due to be implemented from 2022 to 2027, again setting the bar for capital requirements higher, a continuation of the strengthening of European financials’ fundamentals. Despite the strengthening of fundamentals, we continue to capture extremely large spreads and yields on high quality issuers in our fund, with spreads of more than 400bps in GBP.

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