2020 has not been an ideal year for those investors with a nervous disposition, as we have endured an unprecedented level of uncertainty soothed by an equally unprecedented level of monetary and fiscal stimulus. The aftermath of the COVID-19 pandemic remains uncertain, with question marks surrounding the fundamental economic and social legacies this period will leave behind.
As such, we continue to receive more questions of concern and caution about the outlook for bank capital than any other sector; and we totally understand the caution. Following the global credit crisis, there were genuine issues with the very solvency of banks, which led to enormous changes being made to the risks that banks were allowed to take and to the quality and quantity of capital they are required to hold. Despite these improvements, we have said many times that banks need to prove their resilience through the economic cycle before the investor community will regain full confidence in the sector, and we believe this resilience is now being clearly illustrated in how the banks have dealt with the COVID-19 pandemic. The scale of the bad loan provisioning applied in 2020 has been comforting, and the increase in CET1 ratios and buffer capital across the sector should ease the concerns of even the most sceptical market participants. Of course we appreciate that the increase in CET1 ratios has been assisted by the regulators curbing dividends and share buybacks during the year, but the fact is this adverse impact on equity holders has been to the benefit of subordinated bondholders, and in our view from a debt perspective this is making bank debt much less cyclical than it has been in the past.
We also appreciate why many investors are pointing to the considerable recovery in credit spreads for banks since the volatility of early spring, and questioning how much upside is left in the sector. In terms of outright yield the recovery looks complete, given the Coco index was showing an effective yield of 4.08% in January compared to 3.87% today. However, in pure credit spread terms, which we would argue is a better gauge, the Coco index is showing 364bp today versus 290bp in January (OAS spread vs. government bonds).
In a world where spread is becoming an ever scarcer commodity, this 74bp gap looks attractive, but it looks even more so when we consider the spreads that were available on old style subordinated paper issued by banks pre-2008. An article published in the European Journal of Finance in 2014 showed that the mean spread for Tier 1 capital issued by all banks under the ECB’s jurisdiction between 2006 and 2008 was 243bp, and the median spread was a mere 99bp. I accept that not all investors were active pre-crisis and not all would have been invested in these old style Tier 1 bonds, but those of us who were will recall that this product was more akin to IG corporates than it was speculative.
Directly comparing old style Tier 1 to new AT1 bonds obviously disregards the numerous differences between these securities, but to us it does suggest that once the wider investor base has witnessed the resilience of the banks through this period of economic stress, there is still considerable upside from current spread levels as investors price in the structural changes that have occurred in the sector.