Hermes’ Alloatti: The investment case for banks

filippo-alloatti

The asset management industry appears to be split on the future of the banking sector. Depending on who you speak to, the sector represents a great contrarian opportunity or a completely ‘uninvestable’ area. But as Oscar Wilde once opined, “the truth is rarely pure and never simple”.

Investors must not see the case for banks as merely a binary decision. Rather, it is dependent on multiple factors, including whether you are a bond or equity holder; your method of exposure across the capital structure; and whether, as an investor, you subscribe to a long-term, active investment philosophy.

It is our view, that while the sector continues to face existential threats, we believe institutions, such as the ECB, will act to contain any potential contagion risk, and that sector fundamentals have created a number of selective global investment opportunities from a bondholder’s perspective.

Don’t let the equity picture cloud your judgement

Since the financial crisis, the banking sector has made great strides in shoring up capital structures. However, this has been obfuscated by the concerns of equity investors who have grown increasingly apprehensive about the sector. As fears have grown, so has disquiet, reflected in the performance of stock prices. In the meantime, however, banks have been slowly but surely accruing capital to the benefit of bondholders and relief of regulators.

While measures such as rights issues will be viewed as negative for equity holders, we do not predict negative outcomes for bondholders. One example of this dynamic has been seen at Commerzbank; the German bank has been a laggard for equity investors, but a stand-out performer for subordinated bond investors. Furthermore, as other sectors engage in shareholder appeasing activity such as share buybacks and M&A, banks are behaving in a far more bondholder-friendly manner. There is not another sector currently at the same point in the cycle harbouring such capital-enhancing characteristics.

Low rates will not last forever

Ultra-low interest rates and a flat curve have been corrosive to bank profitability. To generate high levels of profits, banks need a steeper curve that supports traditional core banking activity. Some banks, including KBC Group, Lloyds and Intesa Sanpaolo have effectively diversified their businesses to alleviate the situation, but this is not possible for all banks in the sector.

Unfortunately, low rates will continue to subdue profits and balance sheets face a death by a thousand cuts. But from a debtholder’s perspective, it will take a long time for subdued profitability to really imperil a bank. We believe this would only be a real concern, if we are still in an ultra-low rate environment in five years’ time.

The current situation is unlikely to last forever and recent unconfirmed hints by the ECB of QE tapering, for example, is a positive for the sector.

Non-performing loans may have peaked

We think the sector may have peaked on non-performing loans in some regions – for example, in Ireland, where non-performing loans fell from 25% of total loans in 2013 to 15% in 2015. Barring any global catastrophe or deep recession, we predict a slow and incremental improvement in asset quality in some peripheral countries. That said, the sector faces a long and challenging road ahead as bad loans will have to be worked out of the system. This presents a heterogeneous test for global banks, as countries such as Ireland, Portugal, Italy and the US face idiosyncratic risks. This further highlights the need to take a long-term, selective approach to the sector.

Look for opportunities across the capital structure

We live in a new bond world, and investors need start to look at credit in a different way. By only focusing on the quality of a company you have only dealt with the equity risk – not the fixed income risk. You haven’t tackled convexity, duration, illiquidity or volatility by getting the company right.

It is crucial to drill down deeper and get the security right within the company. We have been playing the banking sector for the last six years and currently see some subordinated debt and legacy securities as good entry point to the sector – where you have strong contractual language in terms of coupon payments. Both Barclays and Intesa Sanpaolo look particularly interesting. We also like dollar-denominated floating rate notes issued by the Opcos (operating companies) which are no longer loss-absorbing under new regulations. Moreover, a meaningful shift in the US interest rate curve will make these floating-rate securities more expensive. These factors mean banks are likely to buy them back early.

The importance of applying a global lens

It is important also not to focus on one geographical opportunity set and diversify your credit risk. We see opportunities across the global banking sector. We remain bullish on the subordinated part of JP Morgan’s capital structure and, overall, we still prefer the large money central banks – instead of US regional banks – given the strong, credit-friendly changes that have occurred over the past few years. We are also seeing high-yield opportunities beyond the US and are positive on some emerging market names – for example, Sberbank of Russia.

Filippo Alloatti is a senior credit analyst at Hermes Investment Management.