Equity and credit markets have both experienced unusually violent swings lately. When that happens, we at Lazard Frères Gestion seek to distinguish the facts from unfounded fears so that we can better understand what is worrying investors – and determine whether they are right to be worried. Our economic analysts have shared with you their cyclical outlook on the four fears currently weighing on the markets (Chinese growth, US growth, oil prices and the state of Europe’s banks). To round out that analysis, our bank debt experts present you here with their views on the banking sector. What are investors’ fears in relation to bank stocks? Are those fears justified? And how will the market for bank hybrid securities be affected?
BANK STOCKS UNDER PRESSURE
Securities issued by financial institutions have been having a rough time since the start of the year (see Table 1):
- Bank stocks have shed anywhere from 10% to 58% of their value.
- The credit market has held up better, with Additional Tier 1 (AT1) instruments down by between 6% and 21%.
- In both the United States and Europe, the recent trend has been for spreads on hybrid securities to widen, although they have remained much narrower than during the 2008 and 2011 financial crisis (see Graph 1) .
So it looks like investors judge the current rout comparable to the banking crises of 2008 and 2011, even speaking of a “third banking crisis”.
But however unsettling the recent volatility and dramatic swings in both equity and hybrid security prices may be – and however much they may bring back unpleasant memories – that’s about as far as the comparison goes. In fact, the systemic risk indicators we track on a daily basis are rather reassuring (see Graphs 2 and 3).
A FEW SALIENT FACTORS
- The release of banks’ full-year earnings. Although the picture isn’t complete just yet, the earnings released to date are far from encouraging. By and large, they reflect downward revisions to guidance as the banking sector adjusts to a lower-growth environment and market expectations for falling interest rates.
In addition to disappointing performance in 2015, two other factors will in our view weigh heavily on banks in 2016:
- Oil or even the energy industry as a whole. Compounding the general pressure on banks’ revenues and margins will be a possible downturn in the energy industry. If oil prices stay at their current low level – or even slide further as some pundits are already predicting – banks should brace themselves for lower profits this year. This has prompted analysts at JP Morgan to moot the idea of an earnings crisis.
- Interest rates. Japan and the euro area have apparently adopted an accommodative bias that is increasingly pushing yield curves into negative territory. Meanwhile, the markets indicate it estimates the odds of a hike in US short-term interest rates is close to zero.
The main issue here seems to be profitability rather than solvency; the creditworthiness of Europe’s financial institutions hasn’t deteriorated since 2015. In fact, the continent’s banks still display sound fundamentals, with further improvement on the way. The increase in Common Equity Tier 1 capital since 2007, combined with a programme initiated by the European Central Bank (ECB) to purchase €60 billion worth of assets a month, has given them greater solvency and liquidity (see Graphs 4 and 5).
The plunge in European bank stocks and debt securities seems to stem less from weaker fundamentals than from broader concerns about the economic climate (particularly as we are dealing here with a rather “high-beta” sector that is closely correlated with the business cycle).
SOME CASES WORTH MENTIONING: ITALIAN BANKS, NOVO BANCO AND DEUTSCHE BANK
A number of developments have also contributed to market concerns about the banking sector:
- In the fourth quarter of 2015, four small Italian banks were rescued in 48 hours, which involved “bail-ins” and an 82% haircut on their doubtful loans.
- The ECB has drawn attention to the high level of bad debt in Italy, and if a “bad bank” is established in the country as proposed, that could well drive down the profits and equity of Italian banks.
- The Novo Banco bail-in inflicted losses on only some of the Portuguese bank’s senior bondholders, a totally arbitrary move that flies in the face of the pari passu principle of equal treatment for creditors.
- Deutsche Bank and Credit Suisse both reported full-year losses in 2015. After changing chief executives, both banks recorded hefty one-off charges that tipped their earnings into the red. And panicky reactions by the market (and part of the media) to those losses have intensified fears about the banking sector as a whole.
This suggests that Deutsche’s appointment last year of a new co-chief executive, John Cryan, the former CFO at UBS, didn’t go unnoticed. Mr Cryan is more of a “back-to-the-basics” manager rather than a go-getting business developer. He intends to break with a number of past practices, particularly in the bank’s Markets businesses, and shift the focus of its weighty Corporate & Investment Banking (CIB) division to the most profitable business lines.
It is worth noting that the €6.8 billion loss Deutsche reported in 2015 includes a series of one-off charges: €1 billion in restructuring and severance charges, €5.2 billion in litigation charges and €6.5 billion in impairment of goodwill and other intangible assets (arising on the acquisitions of Bankers Trust in 1999 and Deutsche Postbank in 2010). In 2016, Deutsche will almost certainly recognise additional restructuring and litigation charges, along with impairment of the carrying amount of Deutsche Postbank, a subsidiary that is likely to be spun off some time in 2017. We are clearly dealing here with non-recurring items – and they are what caused such a hit to the German bank’s profits.
Moreover, Deutsche Bank has plenty of cash on hand. German banks as a whole have cash to spare, as shown by the country’s large Target 2 balances – reflecting Bundesbank loans to the ECB (see Graph 6) as well as excess cash at German commercial banks, which they park with the Bundesbank for a remuneration of –0.30%.
Questions are regularly raised about how much capital Deutsche Bank has, but that’s a moot point for creditors since the bank meets the corresponding regulatory requirements, with a fully-loaded Tier 1 ratio of 11.75% as of end-2015. Deutsche’s recent buyback of some of its senior bonds at a discount indicates that the bank has more than enough cash on hand to repurchase its securities. A further advantage of that move has been to slow down what looked like an almost unstoppable slide in the bonds’ market value.
The AT1 market: the drawbacks of being young?
What is doing the most harm in the AT1 market is actually a technical factor. Lured by high coupons and convinced they will be getting the equivalent of bonds, too many investors have jumped on the AT1 bandwagon. It should be stressed, however, that AT1 instruments are not standard bonds, but hybrid securities. That means that in most cases, they will behave the way bonds do, and sometimes will behave more like equities – as the recent correction made abundantly clear.
Plummeting AT1 prices have had two consequences:
- The fears triggered by that price movement have prompted a further sell-off, with a glaring lack of liquidity in the market amplifying the rout.
- Investors confronted with such negative flows are finding it increasingly difficult to take long positions.
Another factor possibly at work is a change in the paradigm for valuing AT1 securities. Following the Wall street adage, “markets make opinions, not the other way round”, the more prices fall – thereby driving spreads up – the higher the cost of refinancing such instruments. With spreads currently widening on previous AT1 issues, investors realise that issuers may well decide against calling their securities – turning them in effect into perpetual bonds.
We consider this an unlikely scenario, however, because it assumes that the market won’t pick up for at least two to three more years. As we see it, jumping to such a conclusion at this stage would not only be rash; it would also be just plain wrong.
We believe that all the banks that have issued AT1 instruments will meet their coupon payments in both 2016 and 2017. Deutsche Bank included. What happens after that, of course, is anyone’s guess. But we believe that investors have good reason to turn to less volatile non-equity instruments offering equity risk premiums of 600 bps or better (see Table 2).
Investor types and liquidity
This brings us to a crucial issue in the Additional Tier 1 space: the types of investors involved and the low volume of AT1 bonds in “stable hands”. Most AT1 securities are held by private investors, hedge funds, specialised investment funds or total return funds – in other words, the broad community of investors exempt from capital requirements. Insurance companies and pensions funds have shown only limited interest, and their relative absence is sorely felt. Yet AT1 instruments have a lot going for them – whatever the state of the financial markets. Unlike bank stocks, they offer a great risk/return trade-off. While they are definitely no replacement for a traditional bond allocation, AT1 securities deliver yield in exchange for additional risk that is amply rewarded by current premiums. And at a time of historically low interest rates and anaemic returns, that is not to be sneezed at. We believe that more and more institutional investors will be moving into this market to diversify their holdings, operating through specialised investment funds and providing some of the liquidity that has been lacking so far.
Conclusion
The primary market has been sluggish for nearly six months now. This suggests that investors are hoarding their cash – an assumption borne out by our recent discussions with final investors in Europe.
What makes this point so crucial are its two key implications:
1)Investors are under no particular pressure to sell securities in order to raise cash.
2)Existing cash reserves could make their way back into the market and spark enough of a rebound in risk assets to offset the outflow of funds from oil-producing countries.
(1)election of securities for each issuer.
The opinion expressed above is dated February 2016 and is liable to change.
Past performance is not a reliable indicator of future performance. The performance should be assessed on the recommended investment period.
This document is not pre-contractual or contractual in nature. It is provided for information purposes. The analyses and descriptions contained in this document shall not be interpreted as being advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute an offer or invitation to purchase or sell, nor an encouragement to invest. This document is the intellectual property of Lazard Frères Gestion SAS.
