European banks: Go for debt

There is concern about European banking equity, and rightfully so. Low and falling interest rates have curtailed profit margins, and are likely to continue to do so: central banks are signaling that monetary policy will remain accommodative, and the implication is that low rates are becoming an entrenched feature. This development is in addition to other, more structural challenges to profitability, such as the gradual erosion of the traditional banking model.

Our view is that this unease about banking equity performance does not apply to debt instruments issued by banks. Whereas equity investors focus on profitability, investors in debt weigh up the creditworthiness of the issuer and treat profitability as one of a range of factors to be evaluated. Despite easing profitability, there is a degree of confidence that the creditworthiness of the European banking sector is intact.

Moreover, we believe that European banking credit offers attractive yields at relatively low risk. Nevertheless, this is a universe in which quality varies and careful issuer selection is essential.

Typically, banking profitability and valuations are squeezed when interest rates fall. Confirmation by the European Central Bank (ECB) that it will maintain its accommodative policy stance signals that interest rates could ease even further and that low interest rates will linger for longer.

Earnings sensitivity to changes in the policy interest rate varies by bank, depending on the revenue composition and balance sheet structure. For instance, banks whose earnings are relatively more reliant on interest income than fee income would be more vulnerable to a scenario of low and falling rates, and particularly so if they rely heavily on shorter-term deposits for funding.

And when policymakers are in rate-cutting mode, this often is at a time of economic weakness and thus of increased loan-loss provisions and non-performing loans, which also dilutes banking profitability.

European banking stocks tumbled during the course of 2018. There was some recovery in the first quarter of 2019, but the gains were reversed thereafter, reflecting equity investors’ concerns about the impact of a low interest rate environment on margins. Equity pricing also reflects worries about how some structural issues in banking are hurting profitability; these include overcapacity in the sector and the way fintech is shaking up the traditional banking business model.

However, in the broader approach taken by a credit investor, which assesses the overall financial position of an issuer in order to determine creditworthiness, the European banking sector looks solid and continues to present opportunities. There are a number of reasons for this view.

Earnings are important from a credit-investment perspective, but equally important is the quality of a bank’s balance sheet.

The good news is that, generally speaking, European banks are still generating relatively healthy earnings, and have a degree of diversification across interest and fee income. Meanwhile, with the ECB acting to stimulate economic growth, the prognosis for the containment of credit risk is good. Therefore, our view is that lower rates combined with the stable economic outlook suggest growth in loan-loss provisions will be benign.

In assessing the quality of balance sheets and thus the ability of banks to service the debt that they issue, credit analysts focus closely on capital adequacy, funding and liquidity.

On the whole, European banks perform well on these metrics. For instance, the European banking sector has shown a steady improvement in its Common Equity Tier 1 Ratio (core capital versus risk-weighted assets), an indication of the resilience of the capital structure. Moreover, statistics show that European banks have a higher degree of buffering against unexpected losses than the global average (see chart).

While all banks have experienced revenue pressures, many – particularly those in northern Europe – have been able to offset the effect through sustained loan growth (see chart) and, to a certain extent, fee income growth.

Compared to many of their southern counterparts, we see stronger evidence among northern European banks of support for the bottom line through cost-cutting and even from reduced growth in loan-loss provisions owing to asset quality. In fact, among the Benelux banks, there have been releases of provisions.

This contrasts with many southern European banks, which are still having to write off loans and are facing difficulties. The Italian banking sector is a case in point. However, we have found the Spanish market to be an exception to the trend: banks in Spain are benefiting from improved fundamentals following the implementation of economic reforms, which in turn have resulted in a significant improvement in asset quality.

Part of the reason for the prevailing low interest rate environment, and the expectation that rates will ease further, is the market view that the ECB will embark on a second round of quantitative easing.

The implications of a new wave of central bank asset purchases are significant for credit markets. One can only speculate at this stage which instruments would be eligible for an asset-purchase program, although it would be reasonable to assume that these would be similar to those targeted in the first round. In the case of credit, this was confined to corporate bonds, to the exclusion of bonds issued by banks.

Judging by history, the likely effect on credit markets of a renewed Credit Sector Purchasing Program (CSPP) is a compression of corporate bond spreads. This is likely to be followed, either simultaneously or shortly thereafter, by the compression of spreads on financial bonds, owing to the anticipated knock-on benefits of increased buyers’ appetite and the search for yield.

Our view is that all European credit markets – including financial bonds – could benefit from QE2, even if financial bonds are not included on the buying list.

We are positive on European banking credit and maintain our exposure to this sector. Our approach in structuring our exposure to this asset category is a cautious one, though, and emphasizes a focus on quality. Given the recovery in the sector since the start of 2019, we are also disciplined about weighing up relative valuations to identify pockets of opportunity.

Our strategy has a selective exposure to Additional Tier 1 Contingent Convertibles (AT1 CoCos), which offer attractive yields and are a relatively safe means of gaining access to the yield opportunity in the European banking industry. It is a diversified strategy, in which the exposure to AT1 CoCos is limited to less than 20%.

We have a preference for Spanish banks, which offer an attractive balance of risk and reward. Together with the boost in asset quality that is now evident in that market, spreads are still at attractive levels on a relative-value basis.