Lloyd Harris, Head of Fixed Income at Premier Miton, argues that the case for Contingent Convertibles has never been stronger.
The contrast between today's post pandemic global economy and the pre-pandemic could hardly be any starker. In particular, the move from a world of very low nominal growth to one where nominal growth is much, much higher. By nominal growth we mean the increase in economic output or income without adjusting for inflation. It’s the raw, unadjusted rate of growth as measured in current prices. It is, in short, the growth in cash terms of the size of the economy. Global nominal growth led by the US has been on a tear...
Source: Bloomberg 31.12.2004 – 30.09.2024
What does this mean for banks? Well, the interesting thing for the banks is that balance sheet growth hasn't kept pace with the growth in nominal GDP. Let us take a look at European GDP versus banking system loan books.
Source: Bloomberg 01.01.2014 – 31.12.2023
Even in Europe, where we’ve had very little growth relative to other parts of the world, banks have got much smaller relative to the size of the economies in which they operate. This gives banks the ability to grow into all this nominal growth. Indeed, if this nominal growth continues (we think it will by the way), banks will have to play catch-up at some point!
Higher nominal growth, driving higher interest rates, driving the return of bank margin!
The by-product of higher nominal growth is of course higher interest rates which is driving the return of margin to the banking system.
Source: Bloomberg Q4 2019 – Q3 2024
It is the return of "net interest margin" that has driven more than anything else, our positive view of the banking sector at the present time versus during the years of zero interest rate policy. The combination of zero, and in some cases negative interest rate policy with quantitative easing, was truly terrible for banking systems around the globe. Banks were unable to pass on negative interest rates to depositors and hence every year that passed, margin reduced and so too did return on equity. Add in the effects of quantitative easing, which flattened the yield curve at the very low level of interest rates, then there was little chance of banks engaging in maturity transformation in order to drive profitability either. The only option was cost cutting in order to keep the lights on. What a different world we live in now.
Banks have also seen off the regulators
In credit, we mostly tend to like strong regulation and post financial crisis regulation certainly made the banking system much safer. We can confidently say that we have passed peak regulation and as a result banks are safer than at any time in living memory. Now that bank regulation has settled down, let’s do a stock-take on the health of the European banking system.
Firstly, let us look at regulatory capital levels which are stable, requirements are also stable and buffers are healthy.
System-wide "core-equity tier-1" ratios (the best quality form of loss-absorbing capital) is at 15% versus 11% requirement leaving a healthy buffer.
Source: Bloomberg Q4 2019 – Q3 2024
High nominal growth and post financial crisis regulation equals solid asset quality
"Stage 3 loans", in other words, 90 days in arrears, have trended down over the last few years and are remaining at the very low level at which we currently see them. We do not expect a material uptick from here even though there's been an uptick in debt servicing costs due to higher interest rates. One of the benefits of higher nominal growth is good asset quality due to higher wages and this trend is unlikely to go away any time soon, especially in the US.
Source: Bloomberg 2006-2023
In much larger economies, this leaves banks to concentrate on what they are best at - lending into the economy, to real households and businesses. Yet although we are still seeing deposit growth, loan balances are dropping due to higher interest rates. With further cuts on the table in Europe in particular, banks are well positioned to grow once we reach a neutral level of interest rates.
All good for contingent capital
Credit spreads in contingent capital have rallied a long way since the depths of early 2023, but we still think that given the strong fundamental backdrop, this part of the market offers one of the greatest risk adjusted returns available. This is particularly the case in EUR denominated contingent capital where spreads are more generous in comparison to their USD equivalents.
Supply demand dynamics reveal the enthusiasm for the asset class
Deals during the autumn of 2024 have been met with robust demand. For example, books on the USD Nordea 6.3% were 9.4x oversubscribed. Whilst supply this year has largely been there to purely replace the existing bonds that have been called by the issuer, we think supply may start to exceed purely replacement. This is as a result of a change in measurement of debt-based capital which should push up issuance need from banks as we enter 2025. Given the fundamentally strong backdrop of the banking system, the market can easily absorb any additional issuance if the Nordea issuance is anything to go by.
In conclusion, a great alternative to high-yield
The bare facts are stark for the case for contingent capital over high-yield. Higher for longer is bad for highly levered high yield corporate issuers with an inability to grow margin to offset the increased interest costs. Higher for longer is unashamedly good for the banking sector though.
This backdrop is good for AT1 creditors in particular which still benefit from being the yieldiest part of the capital structure and a good alternative to corporate high yield which as an asset class is, in the main, undergoing margin compression.
In conclusion, the current environment for banks is one of the most supportive we have seen in living memory. We’ve seen banks get very lean during the post financial crisis years, and now regaining margin from interest rate rises as well. This has made the sector solidly profitable which can be paired with their strong balance sheets. This is a firm fundamental foundation for investing in bank credit and in particular in contingent capital which we believe looks very attractive versus other similarly yielding parts of the market, such as high-yield corporate bonds.