Positive outlook for European bank bonds

Accelerating inflation, the start of another Federal Reserve rate-hiking cycle and Russia’s invasion of Ukraine have triggered a rise in global bond yields and a widening of credit spreads. Although the economic outlook has deteriorated, European banks are entering the slowdown with healthy capital buffers and are in a position to benefit from the rising rates environment. Spreads on subordinated financials have widened to levels not seen since the Covid-19 outbreak and we believe this fixed income asset class now offers good value for investors seeking shelter from concerns about spiraling inflation and tightening monetary policy.

European banks entered the Russia-Ukraine crisis in a strong position with high capital buffers and substantial balance sheet provisioning, which they had bolstered to weather potential Covid-related loan losses. The question is whether they will be able to sustain this resilience in light of the significant economic and financial consequences of the conflict. Based on our analysis, we believe that the financial implications of the conflict for European banks are manageable and that current valuations in the sector more than compensate investors for the potential risks.

Our analysis distinguishes between the direct and indirect impact of the Russia-Ukraine war on European banks. In particular, we consider the effects of direct exposure to Russian assets and banking activities, and the indirect effects resulting from a war-induced slowdown in economic growth and rise in inflation.

Local banking operations and cross-border lending to Russian or Russian-exposed companies could create direct losses for European banks. Banks have a low exposure to Russia, though, at around 0.5% of total lending. Moreover, many of these loans are short-term in nature.

To quantify potential losses for European banks on account of direct exposure to Russia, we did a comparative analysis of two previous crises: the 1998 Russian crisis led to around 60% of loans on average being wiped out, and the 2008-2010 economic crisis resulted in the loss of about 15% of lending. Importantly, in those cases where management had been willing to walk away from local operations, these losses related to Russian operations were limited to the equity investment.

These previous experiences are constructive examples to banks of how to handle the current crisis. They also confirm that the direct effect for European banks is through the impact on earnings rather than on their capital position.

Our conclusion here is that, even in a worst-case scenario, loan losses as a result of direct exposure to Russia would be manageable for European banks and we do not consider this to be a systemic risk.

The indirect consequences of the Russia-Ukraine war could be through a slowdown in economic growth and further rises in inflation. Depending on the severity of these macroeconomic developments, such a scenario would filter into banking balance sheets via elevated loan losses and to a lesser extent through lower revenues. This effect would be mitigated thanks to the robust condition in which banks entered this crisis, with vast buffers relative to minimum capital requirements. Most banks had planned to pay out these buffers to shareholders, but these plans could be scrapped if banking fundamentals were to deteriorate significantly.

We continue to monitor developments closely, but our assessment is that banks’ balance sheets, buffers and profitability currently are at levels that likely would enable them to navigate a stagflationary scenario without breaching critical capital levels. This implies that AT1 coupons would be safe.

Rising interest rates are a welcome tailwind for European banks, and are expected to boost earnings and profitability. German, Italian and Spanish banks have the highest sensitivity to rising interest rates, owing to their funding mix. Among the Spanish banks, for example, we see an upside of 25% in net interest income for some of the banks if Eurozone rates were to rise by 100 bps.

Though credit investors – compared to equity investors – benefit less directly from higher profitability, for certain banks we expect rising rates to be a catalyst to fuel restructuring, to weed out those with mediocre profitability and to underpin the longer-term resilience of the sector. For the European banking sector as a whole, higher profitability following rising interest rates could therefore encourage consolidation and reduce fragmentation. This would help reduce a key systemic risk for the sector.

Spreads on subordinated financials widened out significantly in the first quarter of 2022, reaching levels not seen since the Covid-19 outbreak, the period of taper-related fears in 2018 and the 2016 oil crisis. This spread development is indicative of how the tragedy of the war in Ukraine is having more and more impact on European economies, mainly via the channel of inflation and supply-chain disruptions

As a result of these spread movements, we consider yields on European subordinated financial debt to be looking very attractive compared to investment grade corporate debt.

The Robeco Financial Institutions Bonds strategy invests primarily in investment grade-rated subordinated bank and insurance debt, with some leeway to also invest in high yield-rated AT1 CoCo bank debt (to a maximum of 20% of the portfolio). Table 1 shows the yields of the EUR-hedged and USD-hedged strategies, which were respectively 3.8% and 5.3% at the end of April; the portfolio credit spread was 260 bps. These characteristics compare favorably to the yield and spread of the Global Investment Grade Corporate Bond index, while the duration is significantly lower – at 4.2 years for Robeco Financial Institutions Bonds compared to 7.0 years for the Global Investment Grade Corporate Bond index.

Although the portfolio yield and spread are lower compared to the Global High Yield Corporate Bond index, these characteristics nevertheless look attractive given that the portfolio has a higher relative credit quality.