Bank capital performed well in 2017, and European AT1 securities, in particular, were the star performer, boosted by the economic recovery in Europe. Below, portfolio managers for the PIMCO GIS Capital Securities Fund, Philippe Bodereau and Matthieu Loriferne, discuss PIMCO’s outlook for bank capital in 2018 and regulatory developments affecting the sector.
Q: What is your outlook for bank capital in 2018 and how have you positioned the Capital Securities strategy to take advantage of it?
Philippe Bodereau: When we look at the combination of improving fundamentals, positive technicals and still relatively cheap valuations, bank capital still strikes us as one of a few sectors in global credit that we want to be overweight in – even after last year’s rally (see Figure 1). However, we think it is prudent now after such strong performance to rebalance more broadly in terms of geography and across different parts of the capital structure within the PIMCO GIS Capital Securities Fund.
A year ago, we had a large concentration in AT1 securities, and much of this exposure was in the eurozone1. Since then, we have taken profits on many positions and rebalanced the portfolio. The biggest shift has been our increase in senior debt, mostly in U.S., UK, and Swiss bank holding companies. Senior debt, especially in the U.S., was inexpensive relative to U.S. preferred stock, which is comparable to the AT1 asset class. Since we rebalanced, U.S. preferred securities have underperformed and look more attractive again compared to senior debt, so we think there may be an opportunity to take advantage of better entry levels in the future. We have also made use of our discretion to invest up to 10% tactically in bank equities and now have about 6% in bank stocks, primarily in the U.S.
In all, we are running a more diversified portfolio today than we did a year ago when European AT1 securities were looking very inexpensive.
Q: Has the recent market volatility changed your views on the asset class?
Bodereau: No, quite the contrary: The volatility has reopened interesting opportunities across the capital structure. One of the main reasons we at PIMCO like bank capital securities is that the sector is in very good shape fundamentally, and we are also in the right part of the interest rate cycle. We have seen time and again that banks’ interest income really starts to pick up as interest rates move higher. We believe that’s quite important for investors to take into consideration: Banks are very much geared to higher interest rates and thus can provide a natural hedge and diversifier in a rising rate environment. For example, during the sell-off in equities from 31 January to 9 February European bank stocks outperformed the broader European stock market by about 1.1%, and European banks’ AT1s held up well, outperforming European equities by 5% over the same period.2
We used the recent volatility to buy selectively. For example, we saw interesting opportunities in high quality short-dated AT1s with high reset spreads that we think are very likely to be called.
The Capital Securities strategy has historically fared well in periods of rising rates and delivered positive or neutral returns during the taper tantrum, the Trump reflation moves and the recent period of global
synchronized growth when U.S. 10-year Treasury yields rose by 136, 77 and 59 basis points (bps), respectively (see Figure 2). Even during the German bund sell-off in 2015 (when bunds rose by 54 bps) the strategy
outperformed the Treasury, investment grade credit and high yield markets.
Q: How do you see tax reform affecting U.S. banks, and what could be the impact of potential deregulation?
Matthieu Loriferne: Although the impact of U.S. tax reform will vary from bank to bank, in general it should be a substantial boost to profitability. This not only helps the equity part of the capital structure but also supports senior debt through higher equity valuations.
Deregulation has been discussed throughout 2017, but in reality there has been very little action. Implementing a significant rollback of the Dodd-Frank Act, for example, would mean such legislation would have to pass Congress, and we think that will be very difficult to achieve, especially with midterm elections later this y ear. Instead, we expect small steps in deregulation from the Federal Reserve ‒ for example, modifying the leverage ratio or dividend payment restrictions via the annual stress test. U.S. banks should continue to benefit from extremely strong balance sheets and a resilient macroeconomic backdrop, and we believe that most of the significant positives that were implemented post-2008 will be maintained.
Q: Italy is a focus for many investors. What are the latest developments in the Italian banking system, especially with regard to asset quality and nonperforming loans?
Bodereau: I would say 2017 was finally the year when things got better in Italian banking, with some major positive developments driven by significant pressure from the European Central Bank (ECB). The restructuring of UniCredit with a much bigger-than-expected capital increase and a successful sale of a sizeable pool of non-performing loans was a positive signal for investors. The restructuring plan was very well received by the equity market and has put pressure on other banks, not necessarily to do the same but to go in a similar direction. Although there is still a lot to do in reducing non-performing loans (NPLs) in Italy, we expect the positive momentum to continue in the next few months. The ECB is set to release an important paper in March on the treatment of NPLs, which will drive how fast Italian banks have to act. We are hoping that the ECB takes advantage of the current positive market environment to accelerate the disposal of NPLs not only in Italy but also in Spain, Portugal, and Ireland (see Figure 3). This may result in some banks, in particular those in the second tier, having to raise equity.
Q: What are the key takeaways from the finalization of Basel IV and the publication of the latest Bank of England stress test results late last year?
Loriferne: Basel IV represents the last major piece of financial re-regulation and completes the overhaul of banking regulation launched on the heels of the financial crisis. Although the impact of the new calculation of CET1 ratios will vary (sometimes substantially) across banks, the finalization of the accord is positive and represents a
landmark moment in bank investing. Creditors in particular should welcome the continued reinforcement of European banks’ capital position in the form of higher economic capital set against the same credit risk.
From a market standpoint, the biggest impact will come from the clarity on capital rules this new Basel agreement provides. After almost 10 years of constantly changing goalposts, the regulatory framework is now largely fixed at the global level, and importantly there is no Basel V on the horizon. We think the impact of the new accord on EU banks’ capital positions will be manageable overall (albeit, again, with substantial differences among business models or countries), particularly as the implementation phase is stretched over the next 10 years.
With the Bank of England stress-test results, the key point is that all UK banks passed the stress test for the first time in four years. The stress test was very stringent, with a simulated drop in GDP of 4.5%, a 4% increase in unemployment and a home price drop of 30%. Importantly, no AT1 instruments were triggered this time, which tells us a lot about the robustness of the banks’ balance sheets and their ability to absorb significant macro shocks ‒ one of several reasons why we like UK banks right now.
Looking ahead into 2018, in addition to the ECB paper on the treatment of NPLs in March, a new European stress test will be published in November. We think this new exercise will be interesting from an information standpoint, but will it be a big market-moving event? Most likely not. However, the ECB pressure on banks to reduce their stock of NPLs will be heightened and force the laggards to adopt more aggressive NPL reduction plans, as seen with the Italian banks recently. That is positive from a systemic standpoint.
Q: What is your technical outlook for the year ahead, particularly AT1 supply?
Bodereau: We think supply will be slightly net positive this year. The only reason AT1 instruments exist is to fill regulatory requirements, and we know precisely how much each bank has to issue (see Figure 4). Today, about 85% of required issuance is done. After this year, we expect supply to be flat for a couple of years – meaning the only issuance will be refinancing of bonds that come up for call ‒ while demand will remain strong given the still-attractive yields on bank capital securities compared to other credit asset classes. We believe this benign supply outlook is a key reason for the strong AT1 performance last year; more investors realized that new securities will be scarce going forward.
Q: Putting all of this together, what is the return potential for
the asset class in 2018?
Bodereau: We think a 5%‒8% return in U.S. dollar terms could be
comfortably achieved. The double-digit returns we have seen over the
past several years will be hard to replicate just because current yields are
lower. The core return assumption should be the carry, or yield, of a
portfolio and then opportunistic relative value trades can potentially
add value on top of that. We also see the potential for spread
compression in certain pockets of the bank capital securities market. So
from that perspective, a mid-single-digit return is a realistic target.