Bright spots in EU bank bonds as rates rise

THIS month, the European Central Bank (ECB) decided to raise its key interest rates by 75 basis points (bps). The interest rate on the main refinancing operations will be raised to 1.25 per cent. Since 2016, the interest rate on the main refinancing operations has remained at zero, up until July 2022 where the ECB announced its first interest rate hike after 6 years. The central bank has turned hawkish in its remarks on combating inflation, and so far increased its key interest rates twice in 2022.

According to Eurostat’s flash estimate, inflation is expected to come in at 9.1 per cent in August. Inflation remains elevated in the eurozone due to soaring food and energy prices and supply bottlenecks. Looking ahead, the ECB have revised their inflation projections upwards to 8.1 per cent in 2022; 5.5 per cent in 2023; and 2.3 per cent in 2024. With inflation and interest rates expected to remain elevated, we think European Union (EU) banks are set to benefit.

When interest rates rise, so does the spread between long-term and short-term rates. This helps banks, since they borrow on a short-term basis and lend on a long-term basis. Interest rate hikes help to boost their net interest margins and subsequently improve net interest income.

Additional Tier 1 bonds attractive

Among the EU bank bonds, we think the Additional Tier 1 (AT1) bonds are at attractive levels right now.

Yields on AT1s bonds have risen substantially in 2022. As at end-August, AT1 bonds are yielding close to 9 per cent. The USD AT1 index has an index yield-to-worst (YTW) of 8.78 per cent; the EUR AT 1 index has an index YTW of 8.7 per cent; and GBP AT1 index’s YTW is at 8.89 per cent. AT1 bonds have sold off due to the extension risks being priced in. Investors are expecting banks to not call these bonds; there is fear that recession may affect the bank’s solvency.

We believe that the majority of banks are well capitalised to weather impact on their solvency, and higher rates will bring about more robust net interest margins. Additionally, we have noted that banks have a preference to maintain their reputation, and would choose to call their notes even if they could have it reset at a lower rate.

One example was Credit Suisse, which chose to refinance its 7.125 per cent AT1 bonds with a new 9.75 per cent AT1 bond. Credit Suisse could have saved 120 bps in interest expense if they had let their bonds reset. We think banks consider their reputational risk important, and this plays an important part in their decision to call back their AT1 bonds.

EU banks still well capitalised

As mentioned, banks are well capitalised to withstand any impact on their solvency. The first major test of bank solvency was during the Covid-19 lockdowns in 2020. Banks remained resilient during that period and in fact increased their Common Equity Tier 1 (CET1) ratios above their buffer between 2020 and 2021.

Major EU banks have maintained a significant buffer above requirements, which should be able to cushion any impact on their solvency. We do not think a write-down of AT1 bonds is likely for now, as CET1 ratios for EU banks remain above the stipulated trigger levels for a write-down.

We think the repricing of AT1s provides an attractive entry point for investors to consider adding some AT1 bondsto their portfolio.

Consider subordinated bank bonds

Subordinated bank bonds usually carry higher coupon rates due to their loss-absorbing mechanism, and the lack of a maturity date makes them more akin to equity in nature. We think there are opportunities in the banking sector as banks are able to reap benefits from rising rates. Banks are also well capitalised and able to absorb any impact on their solvency. Investors can consider adding some AT1 or Tier 2 bonds into their portfolio in order to boost their portfolio yield. Some of the issuers we like in the Singapore-dollar AT1 and Tier 2 space are bonds from Societe Generale (SocGen), Commerzbank and Barclays.

SocGen 6.125 per cent Perpetual Corp (SGD) has an indicative yield to next call of 5.75 per cent with 1.6 years to its call date on Apr 15, 2024. We think SocGen’s risk will be reduced from the sale of their Russian subsidiary. On top of that, net interest income is expected to be robust as interest rates in Europe continue to rise aggressively. We like the SocGen 6.125 per cent AT1 bonds for their high initial spread of 4.207 per cent, as well as a short time to its next call date, which makes the bond price less sensitive to interest rate movements.

Barclays’ 8.300 per cent Perpetual Corp (SGD) has an indicative yield to next call of 7.56 per cent with 5 years to its call date on Sep 15, 2027. It has a longer next call date, but we think this bond will be good for investors who have a longer time horizon and want to take advantage of the high coupon.

Commerzbank’s 4.200 per cent 18Sep2028 Corp (SGD) has an indicative yield to next call of 5.7 per cent with around 1 year to its call date on Sep 18, 2023. The rise in key interest rates in Poland resulted in a more than twofold increase in net interest income for their subsidiary, mBank. The CMZB 4.2 per cent 2028 is a Tier 2 bond and has a maturity date on the Sep 18, 2028. We think this Tier 2 bond offers more certainty to investors as there is a fixed maturity date in 2028. At an indicative yield to next call of 5.7 per cent, we think this is a good alternative to AT1 bonds while having comparable yields.

The writer is a senior fixed-income analyst of the Bondsupermart team at iFAST Financial Pte Ltd (IFPL), the Singapore subsidiary of iFAST Corporation Ltd. At the time of publication, IFPL (via its connected and associated entities) has a position in CMZB 4.200 per cent 18Sep2028 Corp (SGD) and BACR 8.300 per cent Perpetual Corp (SGD). The analyst who produced this column holds nil position in these securities.