“Investment grade corporate bonds are priced for perfection,” says Jan Willem de Moor, fund manager of Robeco’s financial bonds strategy. “They are trading just below their long-term historical averages, but their underlying balance sheets are deteriorating, especially in the case of US corporates. European subordinated financial debt continues to offer value while the sector is still in deleveraging mode. Higher interest rates and the steeper yield curve will improve the profitability of banks and insurance companies. Stronger fundamentals, the influence of regulation, and compelling valuations will support long-term total returns.”
Rising yields and steepening curves
Subordinated financial bonds have performed well as investors have rediscovered the attractiveness of the financial sector in the current market. Since 2008, when banks were at the heart of the financial crisis, bond investors have shied away from investing in the financial sector, put off by the low capital buffers and rising number of non-performing loans. The low interest rate environment has been another concern, as this has negatively impacted the profitability of banks and insurance companies.
Since mid-2016, however, global bond yields have started to rise and European yield curves have steepened. “Pressure on the financial sector was relieved by the Bank of Japan’s announcement that it would not lower its short-term interest rate any further. And the Fed had already started to hike rates in December 2015. As of January 2018, the ECB will further reduce the size of its monthly bond purchases. Apart from these changes in central bank policy, the election of Donald Trump was another trigger for higher bond yields, as his plans to stimulate the US economy could push up growth and inflation,” explains De Moor.
In the summer of 2016, financial institution bonds started to outperform those of non-financial companies and their performance accelerated still further in 2017. “We expect this outperformance to continue,” says De Moor. “Regulations like Basel III and Solvency II have forced banks and insurers to reduce their leverage, scale down risky assets and improve liquidity. Their balance sheets are in much better shape than before the financial crisis. We foresee improved profitability for these companies in a climate where interest rates are no longer declining.”
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Picking financial bonds in the light of ECB tapering and Brexit
“We are bullish on banks and insurance companies, but there are still specific issues for certain countries and companies,” states De Moor. “We have a very small exposure to Italian issuers as we are worried about political risk and the stagnant economy. Another area of concern is Portugal, where we have no investments. Scandinavian financials have strong credit fundamentals but are currently not attractive because of low spreads. We are enthusiastic about Spain, though developments surrounding Banco Popular have shown that credit selection remains very important. We did not have any exposure to this bank. Early September, the Catalonian independence issue caused volatility, but as we believed the subsequent spread widening was overdone, we tactically added some risk.”
Besides the quality of the banks and insurance companies in which we invest, a bond’s technical characteristics are also important. De Moor says: “We look at how the bond is structured. A bank or insurer can issue several types of bond with different risk profiles and we have to pick the one that suits us best.”
De Moor likes banks and insurance companies from the Netherlands, France and the United Kingdom. Although Brexit is casting its shadow over the market, he still sees attractive British banks and insurers to invest in. “But we require a higher risk premium.”
Another risk that De Moor sees for the market in general is the further tapering of the ECB bond buying program. “The ECB has announced that it will continue to buy bonds until September 2018, but at a reduced amount”, says De Moor. “We think that the bonds of banks and insurance companies will act as a safe haven in an environment where Central Banks taper their bond purchasing programs, because of the positive effects that higher rates will have on the financial sector. The ECB is not buying financial bonds and the spreads on credits from other sectors are being artificially lowered by the bond buying program. If further tapering occurs, these spreads will rise.”
Figure 1 | Spreads of different subordinations within financials
Source: Robeco, Barclays Live
Compelling valuations for financial bonds
Valuations have not yet caught up with the improved fundamental outlook for the European financial sector in particular, with the subordinated bonds of banks and insurance companies trading on an average additional spread ranging between 75 and 200 bps over government bonds with a similar maturity, compared with a spread of 90 bps for global investment grade over government bonds. Additional Tier 1 CoCos issued by banks are even trading at spreads of more than 250 bps.