Flash – Groupama Axiom Legacy 21
With the recent market correction, financial subordinated debt is offering spreads that we have not seen for a very long time.
- With the recent market correction, financial subordinated debt is offering spreads that we have not seen for a very long time.
- However, overall, the Legacy (1) subordinated debts have suffered less than the new financial subordinated debt instruments (AT1 (2)).
- The current market shock has not stopped the calls of Legacy subordinated debt securities.
Attractiveness of financial subordinated debts
1. Historically strong monetary and regulatory support
The European Central Bank (ECB) and the European Union have just introduced exceptional measures that considerably strengthen the position of subordinated debt holders:
· The market correction is offering spreads slightly above 1000 basis points on the Additional Tier 1 index (AT1, as on 18 March 2020).
However, according to our analysis, the dual crisis caused by Covid-19 and the oil price shock does not pose a problem of solvency for the main banks in our portfolio. This is because, since the 2008 financial crisis, the regulators have forced banks to accumulate very considerable capital reserves. So, the banks are currently very well capitalized to deal with periods of stress.
· The stress tests conducted in 2018 by the ECB provide very precise information on the solvency of the banking sector in a scenario of a major GDP shock: average reduction of 3.9% of Common Equity Tier1 (CET1 (3)) in the adverse scenario on the European banking sector. In our opinion, this is entirely absorbable, given the capitalization levels and the measures announced by the ECB and EU.
· On Thursday, 18 March, the ECB announced monetary and supervision measures that are extremely favourable to the banks (and very protective of subordinated debt holders). In substance:
o Capital: a provisional deferral of the capital conservation buffer (2.5% of CET1) and P2G(4) (Pillar 2 Guidance, specific to each bank). Since then, the countercyclical buffer has been reduced to zero in several countries.
o Liquidity: massive access to liquidity and highly accommodative approach via the Targeted Long-Term Financing Operations (TLTROs).
o Assets: loosened rules, especially with regard to the accounting of non-performing loans, so that banks can provide funding to companies during this period of confinement.
· On 16 March, the EU announced that, pursuant to article 107 paragraph 2 clause b) of the Treaty on the Functioning of the European Union, and in view of the crisis caused by the Covid-19 outbreak, European Member States may, if necessary, provide aid to their banks without this being qualified as extraordinary public financial support, and therefore without any obligatory measures concerning subordinated debts.
·On 19 March, the ECB announced a €750 billion Pandemic Emergency Purchase Programme to purchase public and private sector debt securities.
2. Call at par of subordinated debts
Despite the correction on the financial markets, the banks continue to call at par on Tier 1 debts that have become ineligible (Legacy) or too expensive: For example:
· On 15 March, ING announced that it was redeeming 1 billion euros of AT1 and 700 million euros of Legacy Tier 1 securities.
· On 18 March, SEB announced the call of 1.1 billion euros of AT1 bonds.
1. Performance update
All risky asset classes were down due to the twin shock of the drop in oil prices at the end of February and the worldwide spread of the coronavirus. The subordinated debts sector was not spared. All bonds were adversely impacted, with the most significant movements being on debt securities with distant call dates or perpetual bonds without call date.
Below is a snapshot of performance as on 18 March 2020 :
Data as on 18 March 2020. Source: Bloomberg, Axiom. Groupama Axiom Legacy 21 Share Class P-C, ISIN FR0013251881 CoCos index: Solactive AXI Liquid Contingent Capital Global Market TR Index. Euribor 3-month + 3% capitalized: fund benchmark index. 1 year : from 18 March 2019 to 18 March 2020. Fund launch: 31 May 2017.
Note: the recommended investment period for this fund is 4 years minimum.
2. Portfolio movements
For bonds, we have endeavoured to create value while preserving our cash position intact. In that aim, we have:
o Sold instruments that have a distant trigger and that we can therefore repurchase later, because they are expected to recover more slowly:
- Sale of Société Générale discount perpetual bonds on 02/03;
- Sale of DNB discount perpetual bonds on 03/03;
- Sale of RBS discount perpetual bonds on 04/03, 12/03 and 14/03;
- Sale of HSBC discount perpetual bonds on 10/03;
- Sale of Lloyds discount perpetual bonds on 12/03;
o Purchased instruments with short-term triggers, in order to capture rapid recoveries:
– Purchase of the SEB 5.75 bond, purchased at par 91% on 18/03, with the conviction that the call option would be exercised during the next 4 weeks. The call at par was announced that very afternoon.
– Purchase of the DANBNK 5.75 bond, purchased at par, call announced the next day;
– Purchase of the BKIR 7.375 bond, callable on 18/06/2020, at par 90%, with a call announcement expected within 6 weeks;
– Purchase of the Santander 1% Perp-24 perpetual bond, which yields 9% in euros with the possibility of short-term offer;
– Purchase of Lloyds 12% bond, which was valued at 120 before the crisis. Our scenario is a “regulatory par call”(5) in 2021 (when the security loses its eligibility). This is because the coupon is prohibitive for a security that is no longer eligible as regulatory capital (with a step-up(6) of 1176 basis points after call). This instrument has a yield of 12% in USD on call, but we consider that it should recover strongly as we exit the crisis.
We had established hedging positions and took profit during the market correction.
o Credit hedges:
– Hedge on the iTraxx Senior Fin(7) index, for a nominal value of 10 million euros. We settled this position on 25/02 and 26/02;
– CDS(8) hedge on Intesa credit risk for 6 million euros, settled on 26/02 ;
– CDS hedge on Deutsche Bank credit risk for 10 million euros, settled on 26/02 ;
o Interest rate hedges: we had a long position on German 10-year Future and a short position on Italian 10-year Future. We settled this position on 28/02.
3. Portfolio structure and yield
The portfolio structure, per major category, is now as follows
Data as on 18 March 2020. Source: Axiom.
The average portfolio spread is now greater than 735 basis points, as on 19 March 2020.
For information, the main risks associated with the fund are capital loss risks, interest rate risk, credit risk, liquidity risk, counterparty risk, forward commitment risks, risks of investing in AT1 bonds or “contingent convertible bonds” (CoCos) and risk intrinsic to the use of speculative instruments.
(1) Legacy financial subordinated debts: previous-generation financial subordinated debts (pre-Basel III).
(2) AT1: Additional Tier 1, new subordinated debt instruments, by contrast with Legacy debts.
(3) Common Equity Tier 1 (CET1): in the framework of Basel III, “Common Equity Tier 1” is the most reliable form of regulatory capital, comprising principally the bank’s core capital and retained earnings (disclosed reserves), with certain deductions from the capital reported in the financial accounts (such as deferred tax assets).
(4) P2G: The P2G (Pillar 2 Guidance) recommendation is a capital conservation buffer that enables the supervisor to add to the global capital requirement according to its assessment of the specific situation of each bank. The banking supervisory system of the ECB expects banks to conform to Pillar 2G, even if this is not mandatory.
(5) Regulatory par call: a par call before the date scheduled in the prospectus, if the security becomes no longer eligible to be included in the regulatory capital, following a change in regulations.
(6) Step-up: bond mechanism, which, if triggered – generally when a date is passed – increases the coupon.
(7) iTraxx Senior Fin: CDS basket of senior financial sector debts.
(8)CDS: Credit Default Swaps. A CDS is a derivative product that hedges against the risk of default by a debt issuer.
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Past performance is not a reliable indicator of future performance
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