“Investment grade corporate bonds are priced for perfection,” says Jan Willem de Moor, fund manager of Robeco Financial Institutions Bonds strategy. “They are trading just below their long-term historical averages, but their underlying balance sheets are deteriorating, especially in the US. 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 attractive long-term total returns.”
Rising yields and steepening curves
Subordinated financial bonds have performed particularly well as investors have rediscovered the attractiveness of the financial sector in the current market environment. 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 for investors, as this has negatively impacted the profitability of banks and insurance companies.
Since mid-2016, however, global bond yields have started to rise and 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 in the US, the Fed had already started to hike interest rates in December 2015. As of January 2018, the European Central Bank 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 lead to higher growth and higher inflation,” explains De Moor.
In the summer of last year, financial bonds started to outperform those of non-financial companies. “We expect this outperformance to continue as the outlook for financial bonds is attractive,” 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.”
Dealing with risks when picking financial bonds
“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. We avoid Italian banks and only have a position in insurer Generali as we are worried about Italian 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 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.”
The largest positions in the portfolio are banks and insurance companies from the Netherlands, France and the United Kingdom. Although Brexit is casting its shadow over the market, De Moor 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. “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 up 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. Subordinated bonds of banks and insurers are trading on an additional spread ranging between 130 and 200 bps over government bonds with a similar maturity. For global investment grade, this spread is lower, i.e. 95 bps. And the Additional Tier 1 CoCos issued by banks are even trading at spreads of more than 300 bps over government bonds.
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