Will Rising Rates hurt AT1 bonds in 2018?
As the economic outlook improves all over the world in 2018, we can easily imagine rates will rise both for European and American bonds, expecially for the long-end of the yield curve .
What does it means for the banking sector? I think higher rates will alleviate margin pressures for european banks in 2018, after years of negative rates and huge amount of NPL . But higher nominal margins won’t be the only positive effect for banks balance sheets. Additionally, the improved growth environment ( which would justify the rate normalization ) will also be consistent with an increased demand for credit, and so banks will benefit also from higher volume of loans .
The economic growth means higher rates, and higher rates mean higher profits together with higher loans demand .
Finally , an improving earnings outlook for the European banking sector , will likely drive a compression of spreads for Co.Co.Bonds , and , generally speaking , for all subordinated loans issued by the banking sector .
Obviously improved equity valuations will be the primary beneficiary of improved earnings, but I have always seen a strong correlation bank equity/AT1 bonds : a rally in banks equity in the spring of 2018 ( after the imminent pull-back in stock markets I’m waiting for January 2018…) will also provide support for tighter AT1 spreads . It will be the same story as of the year 2017.
Empirical evidence from JP Morgan Research Analysts suggests that returns on risk asset classes such as High Yield are negatively correlated to returns on 10 Year Government bonds such as Bund or Treasury, as the fundamentals of Non-Inv. Grade firms benefit from the improved growth outlook for the economy. It’s the same story for AT1 returns: they have also demonstrated a negative correlation with US Treasury yield or Bund yield , suggesting that this asset class can also post a resilient performance in a rate normalization scenario, since steeper curves have a direct impact on earnings for the banking sector.
But let me underline another interesting perspective. All Co.Co. bonds are callable. They can be redeemed at par at a certain date. Spread compression would be positive for the asset class as residual extension risk is further reduced. As the spread would compress for these instruments, the likelihood that they would be called would increase (because it becomes incrementally more attractive to refinance them at lower rates ).
In a rising rates scenario we have to stay away from long duration senior bonds, but we have to buy subordinated loans issued by banks with strong balance sheets.
Here You have my favourite picks for this asset class in 2018:
UCGIM 8% USD callable 2024
ISPIM 7% EUR callable 2021
UCGIM 6 5/8 % EUR callable 2023
ISPIM 7.7% USD callable 2025
UCGIM 5 3/8 % EUR callable 2025