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Guess who’s back, banks are back. Financial institutions’ bonds are outperforming non-financial credits and investors are taking notice. “We expect this outperformance to continue as the outlook for financial bonds is attractive.”
Tales of recovery are always interesting for investors. And the bonds of banks and insurance companies currently have an engaging improvement story to tell. The bonds of financial institutions started to outperform those of non-financial companies in the summer of last year and their performance even accelerated at the beginning of 2017.
“We expect this outperformance to continue as the outlook for financial bonds is attractive”, says Jan Willem de Moor, portfolio manager of the Robeco Financial Institutions Bonds fund. “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 banks and insurance companies in a climate where interest rates are no longer declining.”
Subordinated 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 crises, bond investors have shied away from investing in the financial sector. Concerned as they were by low capital buffers and the rising number of non-performing loans. The low interest rate environment was another concern for investors as this negatively impacted the profitability of banks and insurance companies. Since the middle of 2016, bond yields globally have started to rise and yield curves have steepened.
We are bullish on banks and insurance companies, but specific issues still exist
“We are bullish on banks and insurance companies, but there still are specific issues for certain countries and companies”, states De Moor. The concerns of the portfolio manager and his analyst team regarding political and country risk are reflected in the portfolio of Robeco Financial Institutions Bonds.
“We have a very small exposure to Italian issuers. We avoid Italian banks as we are worried about the Italian economy. Other areas of concern are Portugal where we have no investments and Germany where the fund has an underweight position. The German banking sector is very competitive and therefore a low level of profitability. It also needs rationalization. Scandinavian financials are currently not attractive because of low spreads. We are enthusiast about Spain, but only about selective Spanish banks.”
The largest positions in the portfolio are banks and insurance companies from the Netherlands, France, Switzerland 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 ask for a higher risk premium.”
Another risk that De Moor sees for the market in general is a further tapering of the ECB bond buying program. “The ECB has announced that it will continue to buy bonds until the end of the year, but that a further reduction in the monthly purchase amounts can’t be ruled out”, says De Moor. “We think that bonds of banks and insurance companies will act as a safe haven in this case, because of the benefit that higher rates will have for the financial sector. Financial bonds are not being bought up by the ECB. The spreads on credits from other sectors are being artificially lowered by the bond buying program and will rise if further tapering occurs.”
Valuations have not yet caught up with the improved fundamental outlook for the European financial sector in particular. “Investment grade corporate bonds are priced for perfection”, says De Moor. “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 still offers value while the sector is still in a 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 are supportive of attractive long-term total returns.”
The graph below shows the spread development of subordinated financial bonds versus investment grade credits.
The fact that investors have rediscovered financials bonds is also illustrated in the increased demand for mutual funds investing in this asset class. Robeco Financial Institutions Bonds has been a beneficiary of the rising popularity of the financial sector with its assets under management recently reaching the EUR 2 billion mark. In the past five years the fund has shown strong growth and has consistently beaten the benchmark.”