Ten years of regulation and improvement in fundamentals explain how banks have shifted from contributing to an economic crisis, to helping solve one. In this Q&A, Philippe Bodereau, global head of financial research and lead portfolio manager for the PIMCO Capital Securities Strategy, and Matthieu Loriferne, credit analyst and portfolio manager for the PIMCO Capital Securities Strategy, discuss how regulatory trends and improved fundamentals make us believe that the sector offers opportunity for credit investors.
Q: How do you compare this crisis with previous periods of severe market stress, like the global financial crisis in 2008 and the European sovereign crisis in 2011?
Bodereau: The global economic shutdown led to a sudden shock in gross domestic product (GDP), the worst many people have ever seen. Relative to previous crises, though, the big difference is the policy response, which has been much faster, larger in scale and without major policy mistakes. Following both 2008 and the European sovereign crisis in 2011, there was a tendency in Europe to turn to austerity-type measures, whereas this time there has been unprecedented monetary and fiscal stimulus: The U.S. Federal Reserve (Fed) has stepped up with aggressive support, and while the European Central Bank (ECB) initially had a slower response, it has successfully caught up.
The biggest change, however, has been the fiscal response, with Germany putting its balance sheet to work and European Union (EU) leaders agreeing on a Europe-wide recovery fund. This sends an important financial and political signal towards a longer-term commitment to the cohesion of the European project, and this is critical for the long-term financial stability of the Eurozone.
Q: From a fundamentals perspective, are banks today better equipped to cope with such a large economic shock?
Bodereau: In 2008, banks were the accelerant of a crisis that took its roots in poorly underwritten U.S. mortgages. Back then, many banks were over-levered and capital levels, too low. This time, banks are not at the epicenter of the crisis: Their financial position is stronger, asset quality metrics have improved, capital levels are considerably higher, and liquidity concerns are nowhere near where they were in 2008. This is the result of the stricter bank regulations that followed the global financial crisis, and which led to a decade-plus period of deleveraging and balance sheet de-risking across the banking sector (see Figure 1).
Q: Are valuations now reflective of underlying fundamentals or are there any mispricings that may lead to opportunities?
Bodereau: Spreads in financials were relatively tight before the COVID-19 crisis. During the March sell-off, we saw historically wide levels, and since then the sector recouped approximately two-thirds of the widening. Now, we believe any movements from here will be more sideways in the near term and it will take time for valuations to normalize further. However, we believe there are still some attractively priced parts of the market, including, for example, senior bonds issued by some of the strongest European peripheral banks, which lagged during the recovery. With a longer-term outlook, we believe bank spreads are still quite wide, especially relative to other credit asset classes within investment grade and high yield. For example, Additional Tier 1 (“AT1”) bonds1 trade at an OAS (option-adjusted spread) of 536 basis points (bps) (as of 31 July 2020, based on the Bloomberg Barclays European Tier 1 Index), whereas high yield bonds trade at an OAS of 423 bps (as of 31 July 2020, based on the ICE BofA BB-B Developed Markets HY Constrained Index, according to Bloomberg).
While the main risk in AT1 capital is volatility related to macro and regulatory events, high yield investors are now exposed to higher default risk - we are already seeing more bankruptcies in the high yield sectors that are more directly affected by the COVID crisis (which emphasizes how crucial rigorous research and security selection are in credit investing.) Regarding AT1s, they are a volatile instrument, but we believe investors can be compensated for: for example, recent new issues have been priced at attractive mid- to high-single-digit yields. Also, and as it is typical with bonds issued following volatile periods (e.g., 2016, or the second half of 2018), the current vintage of new issues features high reset spreads2. In some cases, the reset spreads are over 200 bps higher than at the start of the year, helping investors better hedge against future extension risk, (i.e. the risk of the bond not being called). We have selectively increased our AT1 allocation via new issues to take advantage of this trend.
Q: Regulation plays an important role in the banking sector. What are the investment implications of the recent regulatory developments?
Loriferne: The sector was significantly re-regulated after 2008, with more stringent rules contributing to improvements in banks’ fundamentals. For instance, Common Equity Tier 1 (CET1) ratios have risen to levels around the mid-teens, up from middle single-digits about one decade ago. However, some of the new regulations introduced pro-cyclical elements that could amplify a crisis in times of economic stress. Because of this, central banks and regulators decided to roll back some of those procyclical measures during the COVID crisis, in an attempt to safeguard the functioning of the banking system, which particularly in Europe is an essential channel for the transmission of monetary and fiscal policy. The European Central Bank (ECB) and the Bank of England (BOE), for instance, have reduced countercyclical buffer requirements introduced in the past years to free up capital and enhance banks’ capacity to absorb losses. Liquidity ratio requirements have been temporarily loosened too.
In the euro area, around €160 billion of bank capital has been freed up because of loosened regulatory measures, including a ban on bank dividends and share buy- backs. This led investors to fear that banks would not only stop paying dividends, but also coupons on AT1 bonds; in response, the ECB reiterated that there is no plan to put any constraints on coupon payments and that restrictions on coupons are only automatically triggered if banks hit certain CET1 capital levels set out in the legislation. The ECB emphasized that banks have significant and ample buffers to use before reaching that point. Indeed, and according to the ECB-SSM (Single Supervisory Mechanism), Eurozone banks have now circa €400 billion of loss-absorbing capital above the regulatory minimum.
Q: Can you tell us more about the impact of the COVID crisis on banks’ balance sheets, and also discuss the risk of coupon-skipping?
Loriferne: We are closely monitoring the cost of risk, i.e., how much banks have to provision to protect their balance sheets against bad loans. The large U.S. banks have adopted an aggressive provisioning strategy to prepare themselves for the expected spike in loan losses. In Europe, we have so far seen a different approach, with regulators incentivizing banks to delay and smooth out the recognition of losses over a longer period, as opposed to front-loading the losses, which would have exacerbated the credit shock and potentially halt lending through the economy. Consequently, lower loan losses were booked in Europe over the first quarter of 2020, but we expect those to increase in the second and third quarter reportings. Still, European banks’ capital buffers remain solid, with CET 1 ratios well above trigger levels and ample capacity to absorb losses (on average 370 bps for the largest Eurozone banks).
In this context, the risk of permanent principal loss on AT1 instruments issued by large EU GSIBs (global systemically important banks) is a very low probability left tail. On aggregate, trigger levels remain far off even if losses across the European banking system reached historical peak multiples – see Figure 2.
A more tangible risk is coupon-skipping, though this will be likely idiosyncratic and specific to a few weaker banks that might not be able to pay coupons for a year or two. As mentioned, the ECB has excluded a blanket ban on AT1 distributions at this stage, at the same time that recent regulatory reliefs have boosted average capital buffers by 100 bps per bank. Most European banks now maintain 200 to 300 bps of buffer to coupon skip-levels even after first-quarter results, which already reflect higher recognitions of loan losses – see Figure 3.
Q: What is your outlook for potential bank sector returns?
Bodereau: We remain positive on the sector both in Europe and the U.S. as, despite recent volatility and significant economic uncertainty, financial institutions remain in significantly better shape than during previous periods of crisis. While financial spreads partially retraced the widening experienced in the first quarter, they remain elevated relative to their long-term history and still offer attractive opportunities in select areas of the market.
Please note that the following contains the opinions of the manager as of the date noted, and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.