October 2019

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  • 1. Clients were asking main difference between AT1 cocos (Tier 1 bonds under Basel III), RT1 (Tier 1 bonds under Solvency 2) and Pref Shares (Tier 1 bonds issued by US issuers)

    Context:The strategy invests in junior subordinated and many of the bonds we invest in are very technical instruments impacted by different regulatory regimes for which the market doesn’t necessarily understand the opportunities and risk.


    Features of financials capital instruments

    Features of financials capital instruments
    Feature Insurance Restricted Tier 1 Bank Additional Tier 1 Bank Pref Shares
    Maturity Perpetual, minimum 5 year non-call Perpetual, minimum 5 year non-call Perpetual, non call (Legacy EU pref)                         Perpetual, callable (Current US pref)
    Coupons Fixed to floater – Fully discretionary, non-cumulative Fixed to Floater – Fully discretionary, non-cumulative Fixed or Fixed to Floating – Fully discretionary, cumulative or not depending on the instrument
    Write-down/conversion Contractual trigger level (usually 75% of requirements or lower than 100% for three months) Contractual trigger level (5.125 or 7%) or Point of non-viability (PONV) No (Legacy EU pref)     Yes (Current US pref)
    Coupon step-up after first call date No No No


    • AT1 cocos instrument are junior subordinated debt securities issued by banks that can qualify as capital under current European Banking Regulation (Basel III). To qualify as Tier 1 capital, the instruments need to be perpetual, have non-cumulative fully optional coupons and a contractual trigger to principal write-down or equity conversion.
    • Restricted Tier 1 instruments are junior subordinated debt securities issued by insurers that can qualify as capital under current European Insurance Regulation (Solvency II). To qualify as Tier 1 capital, the instruments need to be perpetual with a minimum five-year non-call, have non-cumulative fully optional coupons and a contractual trigger to principal write-down or equity conversion.

    Although insurance RT1s have similar feature as banks AT1 (perpetual, fully discretionary coupons and a contractual trigger) we view the risk for investors as different. Unlike banks, there is no Insurance bail-in regime where an instrument can be written down when an issuer reaches the “Point of Non Viability” (PONV) – which is at the discretion of the regulator when a bank is deemed failing or likely to fail. This reduces the risk of an early regulatory intervention to impose losses on creditors or force coupon cancellation. Secondly, there is no Minimum Distributable Amounts (MDA) trigger – which is the amount of capital required for banks to be able to make coupon payments, typically well above the trigger level. For European banks, this creates incremental coupon risk, not present in insurance RT1s. Overall, the risk from the features of the bond is lower in our view compared to bank AT1s, as for RT1s coupon skip risk arises at very remote levels and there is no bail-in regime.

    • Pref Shares in general are junior subordinated debt securities issued by US banks with very similar features as AT1 CoCos .

    To be noted that the Pref Shares we hold in the fund are mostly legacy capital securities issued by banks and insurers under previous regulatory regimes, and hence these are not issued any more as they would not be eligible as capital going forward. These old style pref were usually issued for taxation efficiency purposes as the coupon on such securities was tax deductible like a normal bond despite they were accounted as equity capital and were non callable fully perpetual non cumulative coupons kind of bonds.

    In this regard, our reasoning behind the lack of involvement in US modern prefs is driven by valuations, where European banks offer significantly wider spreads. For example HSBC 6.375% AT1 CoCos callable in 2024 currently offers a spread of c350bps over treasuries, compared to c220bps spread for JP Morgan 6.125 US Pref callable in 2024. This is despite similar ratings (both BBB- Bloomberg Composite) and similar bond structures.

  • 2. Clients were asking how the spreads level for our investment universe has been evolving in the last few years

    Context:The investment team consider the current valuation level on our securities very attractive as reflected by spreads, which are still very wide if only compared to end of year 2017, levels at which the team was considering getting closer to a fair value for our asset class.

    Impact for the fund: Positive as the markets are showing strong momentum and spreads on our asset class are still very wide. This shows a potential for high capital gains going forward as it has been

    The continuation of the multi-year process of capital strengthening for European financials makes us feel very confident in the strong and improving credit fundamentals of our issuers.
    Although prices have continued to rally, spreads has tightened only 170 bps YTD which sets us on average at 1/2way towards the level of end of 2017 where we were feeling levels were getting closer to what we see as a fair value for our asset class.


    We feel that current spreads (c390bps on AT1 CoCos for example) remain highly attractive and see further upside as well as continued high return contributions from income collected. Dovishness by central banks and a low rates environment bodes well for subordinated fixed income of financial sector. We feel the quality beta of our strategy is the right answer to the continuous geopolitical issues (Trade wars and Brexit) and uncertainty related to global growth i.e. high and steady income from strong issuers.

    happening on a YTD basis.

  • 3. As we hold a big portion in CoCos client is asking what these securities are and what is the attraction to holding these in the portfolio.

    Context:By holding approximately 25% of exposure to the asset class and being this the most subordinated and technical to understand, clients are asking the rationale for holding them and how this securities works

    Impact for the fund: Positive, this is not simply a source of differentiation against our competitors but the reason we want to limit our overall exposure to this asset class is that AT1 coco are more risky than Tier 1 bonds issued under Basel II and Tier 2 bonds from banks. The reason why these are more risky is that for example coupon risk is more elevated as based on regulatory requirements set by Basel III, coupon have to be discretionary and non-cumulative. As our objective is to capture a “high and steady” income from strong companies, this is the reason why we have given a soft guidance of 25% on AT1

    AT1 cocos are all fixed-to-floater perpetual with a high coupon and because of the re-fix of the coupon, on average after 5 years, it makes them also an extremely valuable instruments in a rising rate environment.

    So great carry, attractive valuation and low sensitivity to rates.

    On the other hand, coupons on AT1 Cocosare fully discretionary and non-cumulative. Meaning that not only at fully discretion of the issuer but also the regulator can block the payment of the coupon on such securities which being non-cumulative would result into a loss of accrued income for the funds. In addition the contingency is a pre-set CET1 level and a breach of it means either a conversion into equity or a write-down of the principal as defined by the respective prospectus.

    On the coupon that is the main reason why we give ourselves a 25% soft guidance limit while concerning the risk of conversion our strategy bodes well with this asset class as we are selecting only national champions that already met Basel III requirements and the risk of conversion for such issuers is very low.


  • 4. What is a CMS / CMT?(bond where coupon is not fixed and regularly reset based on swap/interest rates)

    Context:These bonds tend to be correlated to interest rates and as rates went lower, the price of these went lower too. The bonds that we own have been issued under Basel II and Solvency 1 and do not comply with new regulatory framework. We call them grandfathered. There is a lot of optionality owning such bonds in terms of future capital gains as banks/insurance companies will be looking to buy back such bonds at significant premium to current prices over the coming years.

    Impact for the fund:Positive, as the market started pricing the potential regulatory call for loss of eligibility on such legacy bonds

    CMS: Constant Maturity Swap

    CMT: Constant Maturity Treasury

    Discounted Perpetual Floating Rate Notes (FRNs) are legacy capital securities issued by banks and insurers under previous regulatory regimes (pre-Basel III for banks and pre-Solvency II for insurance). There are two broad categories of Discount Perpetual FRNs: Discount Perpetuals (DISCOs) and Constant Maturity Swap (CMS) or Constant Maturity Treasury (CMT) instruments. Given there is currently close to USD 15 billion outstanding securities in issuance between DISCOs and CMS/CMTs, this asset class remains a sizeable portion of the legacy subordinated debt market.

    Both DISCOs and CMS / CMT instruments share common features, both being:

    • – Perpetual subordinated debt instruments issued under previous regulatory regimes
    • – Floating coupons with low margins (where the spread is paid above the reference rate) – typically below 50bps
    • – Periodically callable – this could be annually or more frequently

    Given low floating margins, both instruments trade at deeply discounted prices to reflect these relatively low coupons. However, DISCOs are mostly US dollar-denominated instruments that were issued by banks in the mid-1980s and are indexed to Libor, while CMS / CMTs are mainly euro-denominated instruments issued by both banks and insurers in the early to mid-2000s (with some US dollar issuance) that are indexed to 10- year swap rates or government bond yields.


    For more insights please refer to our article on Discos: “An opportunity in subordinated financial bonds?”

  • 5. Clients asking if the investment team has a guidance for performance expectation in 2020

    Context: Given the combination of strong fundamentals and attractive valuation levels, our base case for the next 12 months in terms of performance of the fund is not only income but further capital appreciation too. Hence the performance guidance of 9% for the EUR fund, 10% for the USD fund and 10% for the GBP fund.

    Impact for the fund:Over the next 12 months performance guidance of 9% for EUR and 10% for both

    We keep seeing strong improvement of credit metrics within European financials. Moreover, the multiyear regulatory processkeep forcing financials to build up capital and strengthen their balance sheets, all of which are supportive from a credit perspective as confirmed by the latest session of results. We expect holders of financials’ subordinated debt to benefit the most from this. Furthermore, with spreads of these securities currently above 400 bps, valuations remain extremely attractive.Last but not least we see significant value in legacy capital securities of banks and insurers which offer attractive features in a portfolio context and attractive valuations.
    Given all this, we feel the fund going forward has scope to benefit not only by the usual high steady income but from potential further high capital gains.
    Guidance for next 12 months is 9% for Eur fund and 10% for usd/gbp fund. Of which half coming from income and remaining from price appreciation

    GBP and USD

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