La Française: Outlook for Subordinated Debt in the coming months

13 april 2023

The full write-down of Credit Suisse’s AT1 CoCos has been a shock for all stakeholders, both from market and reputational standpoints.

Many investors were still hoping until the very last hour that their bonds would be potentially at least partially saved. Others argued that the fact that 'creditor hierarchy' had not been respected, since CoCo holders were wiped out, while shareholders still got a little something at the end of the day, could cast a shadow on the whole asset class. We do not share these concerns.

CoCos are meant to absorb losses, should the bank be considered as “failing” or “likely to fail”, and European jurisdictions (aside from Switzerland) are very clear about this, as was confirmed by the ECB or the Bank of England, which also hinted that they would have handled a similar situation in a different way. At the end of the day, financial stability was preserved and Credit Suisse, which had been suffering from self-inflicted woes for several years, was taken over by UBS.

We remain very confident about the fundamentals of European banks, which do not share the weaknesses of Credit Suisse, nor those of smaller American institutions, which were deregulated under the Trump era. We do not believe that the market panic that has affected the share and bond prices of other European banks was supported by any evidence. Still, the stigma of such a credit event is significant and flows in subordinated debt may likely remain subdued for the time being.

Opportunities

Yields have obviously exploded on €AT1 CoCos (11.9% as at 30/03; Bloomberg EUR Contingent Convertible Index) and prices are very low, as a reflection of the shock on the market and the fact that they no longer price any 'call options'.

The potential to rally can be exacerbated by this convexity, but it is important to remain wary of their volatility at the moment, as several subordinated debt funds have been hit by Credit Suisse and may have to deal with further outflows, as well as some 'tourist' investors, who may become less active in this market for some time.

Still, even if you do not assume any call option for these bonds, AT1 CoCos can offer a very attractive carry with yields-to-perpetuity currently between 7% and 13%.

We see opportunities in Tier 2 bonds from banks and insurance companies in Europe, whose coupons, contrary to AT1 CoCos, cannot be skipped and which are senior to Tier 1 CoCo bonds, as well as Hybrid bonds from non-financial corporate issuers, which can offer attractive premiums, relative to similarly rated senior unsecured bonds.

Diversification on the subordinated debt space, both sectorial and in terms of seniority, is in my opinion a way to benefit from current opportunities.

Interesting sectors and regions

Bond volatility is still very high, both on rates and credit bonds. As such, it is possible to mitigate such volatility with high-coupon carrying bonds and liquid bonds. The ability to trade decent sizes of bonds at all times is of the utmost importance in times of stress, and as asset managers, we view as a requirement to focus on bonds with significant outstanding sizes, i.e. above € 500m.

In our opinion, it is also important to focus on national champions at the moment, which bolster strong fundamentals along with robust retail networks, which should give them more stability on their solvency and liquidity profiles. More than ever, it is mandatory to stick to fundamental analysis, as chasing very elevated yields also means that you have to forego liquidity and quality.

Smaller issuers, and especially regional banks in Europe or smaller local players, still bolster very good fundamentals, but liquidity on their bonds is not yet sufficient to offer a decent risk-reward ratio, in our opinion. Sticking to core and big issuers on liquid bonds could be a way to ride the volatility wave and still enjoy a very decent carry.