Given the ongoing volatility in the banking sector, Kim Catechis, Investment Strategist with the Franklin Templeton Institute, recently hosted a webinar with David Zahn, Co-Chair of the Stewardship and Sustainability Council and Head of Europe Fixed Income with Franklin Templeton Fixed Income, to discuss their perspective on recent events, where we are now, and what the implications are for markets in Europe and globally.
- One week on from a shotgun marriage, credit markets seem more composed than rates
The markets appear to have largely digested the events of last week, but we now see the credit markets demonstrating more composure than the rates markets. That’s unusual, and we think it’s a strong signal from investors. We have seen that many of the spread markets are not moving as much as we would expect, excluding the AT11 (Additional Tier 1 bonds) market. It does seem that the rates markets are pricing in that we’re going to see rate cuts from the central banks, which we think is probably not appropriate. It’s really the rate volatility that is the most extreme, as opposed to say high yield or credit, which has not been nearly as punished. The rates market is trying to figure out what’s going on, whereas normally that’s a calmer market than the AT1s. It makes sense, as we did witness that big selloff of the Credit Suisse AT1 bonds last week.
- AT1s are not dead—just reserved for the biggest and strongest
The write-down of the Credit Suisse AT1s made investors question: Is this asset class viable? Overall, we still think it’s a viable market. But it’s going to be different in the future—only the bigger banks are going to be allowed to issue AT1s. Smaller banks will likely struggle to issue their AT1s, so they may have to go back to more equity, which isn’t ideal from their perspective, but does makes sense given circumstances. We have seen a bounce back from the lows, but it is obvious that investors are still trying to get comfortable with the likely outcomes. For example, does this mean that banks will require more permanent capital as opposed to bonds that can be called? We think the process will still take some time, but the yields on AT1s are now really high, in the region of 9% to 11%. That’s the level of yields that will probably attract buyers once we see more stability.
- The hierarchy of equity and bondholders still holds—officially
Everyone now knows that the Swiss banks (UBS and Credit Suisse) do have this clause that allows the regulatory authorities to execute a permanent write-down in the event of government involvement, just as they did in the case of Credit Suisse AT1 bondholders. All the other regulators in Europe and the United Kingdom have come out and said that they believe the equity needs to be wiped out first before the AT1s. And that’s the way it’s written in their prospectuses. This should provide some comfort, but some investors may look back and just say, well, it’s been done before, so it could happen again. In theory, anything is possible. But overall, it looks like a different market now. Investors are going to focus on the standard calculation: What is the risk versus return?
- The balance between equity and fixed income
Given the turmoil in capital markets and the surprise reverse hierarchy of the Credit Suisse resolution, investors are reconsidering their options in terms of how best to gain exposure in the banking sector. Thinking about a future with higher levels of regulation, higher capital requirements, potentially explicit limitations to certain activities and higher cost of capital, equity investors will wonder if it is worthwhile to take on the sector risks for structurally lower Return on Equity (RoE) and Return on Assets (RoA) than they have been used to. Maybe it’s turning into a sector for fixed interest? For bond investors, the senior debt, Tier 3 and Tier 2 issuance will be attractive parts of the capital structure. Tier 1 will be different, the natural buyers will be a reduced number, meaning a restricted pool of investors and, again, at a higher cost of capital. Something to watch!
- Banks should remain central to European economic activity but pay a higher cost of capital
Clearly bank regulation will be more intense and banks will have to pay more for capital over the next several years, because they are now seen as riskier institutions. The investors’ perspective will be to demand a higher yield to own banking debt all the way up the capital structure, not just AT1s. But has anything fundamentally changed regarding how investors look at banks? Probably not. European economies are arguably more reliant on the intermediation of banks than in the United States; as a result, the regulators will avoid impinging on lending activities. A central focus will be the stability of the banks so that they can continue to help turn the wheels of economic activity. The recent volatility has clouded the situation, but ultimately investors will continue to invest in banks, albeit at a higher threshold asking price. Exactly how much higher will become clear when the interest-rate cycle is settled.
- The guessing game around interest rates continues
Reading the signals from the bond markets on both sides of the Atlantic, it seems that they are pricing in rate cuts. Logically, this makes investor sentiment cautious. What does this tell us? Does it suggest we are heading into a recession? We don’t think so. Our base case is that we are unlikely to get rate cuts this year. In this scenario, owning relatively riskier assets probably makes sense. But we observe a lot of investors preferring to stay on the sidelines, to watch rather than to take action. We believe that there is an opportunity in rates, at the shorter end of the curve. Many are questioning if the traditional 2% inflation objective still holds.
We think it is still appropriate. Over the next couple of years, they will be at higher levels, but that’s where central bankers are getting a little caught up in the current data, and not enough in the forward-looking data because inflation expectations have not become an anchor. From that perspective, they want to make sure those inflation expectations two or three years out are really kept low. This could, of course, change very much in the next six months, depending on how inflation data comes out, possibly triggering a change. Remember that for a long time, especially in Europe, we had an inflation target of just 2% that we didn’t meet for almost a decade. We believe that inflation pressures will be higher over the next couple of years, but you do want to bring it down to that lower line in the medium term.
- Good corporate citizenship is now central to the investment case
Clearly we don’t know all the details yet, but French prosecutors yesterday reportedly raided the Paris offices of BNP Paribas, Société Générale, Natixis, HSBC and several other banks as part of an alleged tax evasion scheme associated with dividend payments. It is related to an equivalent investigation in Germany that has already resulted in senior bankers and a tax inspector being imprisoned. While this event does not necessarily imply any liquidity or solvency risks to the institutions, it does add a layer of concern around environmental, social and governance (ESG) considerations and tarnished reputations.
Our early conclusion is that episodes like this are evidence of our fiduciary duty, of our obligation to look at the sustainability of our investments, and the behavior of these corporates and their management teams. It is an important area that will continue to be a focus. We want to first establish the facts: Is it a system-wide problem, is it confined to individual banks? How does that affect the sustainability of their business models? All the more damaging if you’re a bank that says it embeds sustainability in its business, are you in the clear in these situations?
Audience questions:
Do short sellers and investment bankers take advantage of the mistakes of bank managers to try to force the central banks to change policy?
What is the bond market trying to do? Is it trying to force the central banks to cut rates by pricing aggressively? That would be almost the opposite of the bond vigilantes.2 That could be what a segment of the market is trying to influence. But we had a huge number of short positions built up in rates even prior to this whole event. And we’ve seen several market players hit quite hard because they’ve had to cover their shorts quite quickly, which probably exacerbated this move. However, we believe that the central bankers are quite clear that they’re not going to deviate. Inflation is still a problem. We don’t know if it’s coming down. We don’t want to make the same mistake that we made in the 1970s. We’ll make a different mistake of course, but not the same mistake. The central banks are going to continue along their process and that’s why we have an opportunity to shorten up duration at least for the short term and look to add over the next three to six months.
Does this situation, in your opinion, lead to deposits in banking systems being kept in central bank digital currencies (CBDCs)?
We are unlikely to see that in the short term, but we’ll see treasurers worrying about their treasury function. And clients’ individual exposure to banks is becoming much more diversified. Will the orientation toward money markets keep growing? In Europe there are many governmental programs that issue bonds or launch deposits that are fully guaranteed by the state and offer quite attractive value. On the flip side, you probably want to diversify your country exposure. There is no doubt we will see more diversification and at some point, maybe we do see CBDCs taking some deposits.
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1. An AT1 is a form of Contingent Convertible (CoCo) bond which a bank struggling financially does not have to repay.
2. A bond vigilante is a bond trader who threatens to sell, or actually sells, a large amount of bonds to protest or signal distaste with policies of the issuer.
