Steady Fed makes short end look attractive
European bank equity has been among the hardest hit sectors since Russia’s invasion of Ukraine, as fears of losses and a flight to quality have prompted investors to change positioning. This reaction is exactly what one would expect in this situation; banks have always generally been viewed as higher beta risk-on positions, and investors feel confident that a ‘sell now and ask questions later’ strategy will pay off in the short term as risk-off sentiment rages through the market.
In the bond markets, subordinated bank debt has similarly been among the hardest hit, with the ICE BofA Contingent Capital (Coco) index losing 5.35% year-to-date, reflecting a spread widening of 133bp. In fact, the yield in the sector has risen sharply to 5.32% today from just 3.02% back in September. Even lower rated junk debt has outperformed subordinated bank debt, with YTD returns in US high yield at -3.62% and in Euro HY at -4.71%.
While this natural risk aversion is logical in the current market, we do not think it is fundamentally well supported, and should eventually present investors with an opportunity. We are confident that Russian and Russia-related credit exposures are not about to overwhelm the European banking system. In fact, the current dynamic rather reminds us of the period in late 2015 and early 2016, when fears of losses stemming from plunging commodity prices caused a similar sell-off in bank debt and was being hailed as the next catalyst for a new financial crisis. As we know this turned out not to be the case; banks very quickly articulated their very manageable exposures to the sector and a strong rally ensued.
Russian and Russia-related credit exposures at European banks are extremely low – they are estimated to be less than 1% of total exposures across the sector. It should also be noted that the risk weightings banks are required to attach to Russian assets are high, meaning these exposures are also well capitalised. Much has been written about France’s Société Générale and Italy’s UniCredit, where exposures are higher, but in our view these are also very manageable in the context of their very high levels of capitalisation. Bloomberg Intelligence estimates that a full write-down of Russian exposure at SocGen and UniCredit would only result in a drop of 30bp in each bank’s common equity Tier 1 (CET1) ratio. Looking at some outstanding bonds, SocGen’s four-year AT1 in dollars was trading with a yield of nearly 7% as of Thursday morning, and UniCredit’s six-year AT1 in euros was also close to 7% (which in dollar terms would be closer to 8%), which we think really does not reflect the actual credit risk that comes with exposure to two of Europe’s pillar banks. We can understand why there may well be a hit to earnings at these banks given their higher exposures to Russia, but we do not think a material hit to capital is likely even in a scenario where European GDP suffers as a consequence of the sanctions being imposed.
It is very hard to make predictions while geopolitical events dominate the news, and even harder to pick the bottom in markets while the situation is so fluid, but we do not think this is a time to panic when it comes to holding subordinated bank debt. Conversely we think investors will be rewarded for their patience and those looking to add will probably enjoy enhanced coupon income and some capital gains in the medium term.