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.

Strong outperformance of AT1 securities

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.

Capital Securities strategy: lower sensitivity to interest rates

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.

Asset quality in periphery not resolved yet

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.

European banks’ AT1 required issuance

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.


1 Additional Tier 1 (AT1) instruments are hybrid capital securities that absorb losses when the ratio of common equity tier 1 (CET1) divided by risk weighted assets (RWA) of the issuing bank falls below a certain level.
2 European equities represented by the Stoxx Europe 600 Index, European banks represented by the Stoxx Europe 600 Banks Index and AT1s represented by the Barclays European Banks AT1 CoCo Index.
The Author

Philippe Bodereau

Portfolio Manager, Global Head of Financial Research

Matthieu Loriferne

Portfolio Manager, Capital Securities and Financials

Related

Disclosures

For professional use only

Past performance is not a guarantee or a reliable indicator of future results.

GIS FUNDS: PIMCO Funds: Global Investors Series plc is an umbrella type open-ended investment company with variable capital and is incorporated with limited liability under the laws of Ireland with registered number 276928. The information is not for use within any country or with respect to any person(s) where such use could constitute a violation of the applicable law. The information contained in this communication is intended to supplement information contained in the prospectus for this Fund and must be read in conjunction therewith. Investors should consider the investment objectives, risks, charges and expenses of these Funds carefully before investing. This and other information is contained in the Fund’s prospectus. Please read the prospectus carefully before you invest or send money. Past performance is not a guarantee or a reliable indicator of future results and no guarantee is being made that similar returns will be achieved in the future. Returns are net of fees and other expenses and include reinvestment of dividends. The performance data represents past performance and investment return and principal value will fluctuate so that the PIMCO GIS Funds shares, when redeemed, may be worth more or less than the original cost. Potential differences in performance figures are due to rounding. The Fund may invest in non-U.S. or non-Eurozone securities which involves potentially higher risks including non-U.S. or non-Euro currency fluctuations and political or economic uncertainty. For informational purposes only. Please note that not all Funds are registered for sale in every jurisdiction. Please contact PIMCO for more information. For additional information and/or a copy of the Fund’s prospectus, please contact the Administrator: State Street Fund Services (Ireland) Limited, Telephone +353-1-776-0142, Fax +353-1-562-5517. © 2018.

Benchmark - Unless otherwise stated in the prospectus or in the relevant key investor information document, the Fund referenced in this material is not managed against a particular benchmark or index, and any reference to a particular benchmark or index in this material is made solely for risk or performance comparison purposes. Additional information - This material may contain additional information, not explicit in the prospectus, on how the Fund or strategy is currently managed. Such information is current as at the date of the presentation and may be subject to change without notice. Investment Restrictions - In accordance with the UCITS regulations and subject to any investment restrictions outlined in the Fund’s prospectus, the Fund may invest over 35% of net assets in different transferable securities and money market instruments issued or guaranteed by any of the following: OECD Governments (provided the relevant issues are investment grade), Government of Singapore, European Investment Bank, European Bank for Reconstruction and Development, International Finance Corporation, International Monetary Fund, Euratom, The Asian Development Bank, European Central Bank, Council of Europe, Eurofima, African Development Bank, International Bank for Reconstruction and Development (The World Bank), The Inter American Development Bank, European Union, Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac), Government National Mortgage Association (Ginnie Mae), Student Loan Marketing Association (Sallie Mae), Federal Home Loan Bank, Federal Farm Credit Bank, Tennessee Valley Authority, Straight-A Funding LLC.

RISK: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of US government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government. Certain US government securities are backed by the full faith of the government. Obligations of US government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. This fund may invest in contingent convertible securities (‘Cocos’). CoCos have unique risks, for example, due to equity conversion or principal write-down features which are tailored to the issuing entity and its regulatory requirements, which means the market value of CoCos may fluctuate and be unpredictable. Additional risk factors associated with CoCos are set out in the fund’s prospectus.