PIMCO Capital Securities Strategy Update: Banks Show Remarkable Stability Amid Pandemic-fueled Disruption
- Following the COVID-19 pandemic, bank fundamentals in developed markets have not only remained resilient but have even improved, supported by policy interventions and regulatory forbearance measures.
- Nonetheless, the recovery in AT1 spreads has lagged generic corporate credit. We expect the perceived riskiness of the AT1 asset class to moderate, which should help close the gap in valuations relative to high yield bonds.
- PIMCO’s outlook for capital securities remains constructive, particularly relative to generic corporate credit. Major risks relate to macro-driven volatility and extended lockdowns, while idiosyncratic risk remains subdued within the banking sector and the recent increase in yields and steepening of curves is supportive for bank fundamentals.
Despite the unprecedented economic disruptions of 2020, a combination of supportive policy interventions and a decade-long de-risking of balance sheets explain surprisingly resilient bank fundamentals in developed markets. In this Q&A, Philippe Bodereau, lead portfolio manager for PIMCO Capital Securities Strategy, and Matthieu Loriferne, credit analyst and portfolio manager for PIMCO Capital Securities Strategy, discuss how banks coped with the COVID-19 crisis and what opportunities lie ahead for investors as the global economy moves from hurting to healing in 2021.
Q: Following the outbreak of the pandemic, we had an unprecedented GDP shock in 2020, and certainly one of the sharpest recessions in history. Looking back at the year, did banks perform according to expectations?
Bodereau: This has been the first big real-life stress test following the global financial crisis. For over a decade, regulators in the U.S. and Europe have been busy shoring up the defenses of the banking sector, which resulted in aggressive de-risking of balance sheets, much higher capital ratios, and lower risk appetite overall. The resiliency of the reformed and de-risked banking system was put to the test by the COVID-19 crisis, and while there are still uncertainties ahead, it is fair to say banks passed this test with flying colours. In fact, no bank was resolved or failed in 2020, the vast majority of AT1Footnote1 (Additional Tier 1) bonds were called at their first call date (except for only two bonds), and no bank suspended coupon payments on its AT1 bonds.
Banks have been able to cope remarkably well given the magnitude of the gross domestic product (GDP) shock and even acted as a conduit for providing liquidity to the corporate sector. From a balance sheet perspective, not much went according to the playbook, with banks reporting even higher CET1Footnote2 (Common Equity Tier 1) ratios by the end of the year, which is the opposite of what you would expect in a period of economic contraction. In this respect, 2020 turned out to be a bizarre year for bank fundamentals, with counterintuitive balance sheet dynamics compared with a traditional recession.
Q: What contributed to the resiliency of banks’ balance sheets and even improvements in bank fundamentals, including an increase in capital ratios?
Bodereau: CET1 ratios went up due to a combination of retained earnings, relatively low growth in risk-weighted assets, and some relaxation of regulatory constraints. Regulators restricted payouts such as equity dividends and buybacks, while at the same time inviting banks to smooth out losses over multiple periods by avoiding front-loading loan loss provisions, especially in Europe. The regulatory response has boosted banks’ capital buffers and safeguarded the functioning of the banking system, which is viewed as an essential conduit for a number of monetary and fiscal policy tools.
What made this crisis unique was not only the violence of the GDP shock, but also the rapid and dramatic response of both monetary and fiscal authorities. Banks have been indirect recipients of many of those support measures. The provision of ultra-cheap long-term funding, such as the TLTROFootnote3 in Europe, has supported the liquidity of bank institutions through this crisis with very limited signs of stress compared to the 2008 financial crisis or the more recent euro zone sovereign crisis in 2011-12. Large and coordinated fiscal policy interventions, with government measures including furlough schemes and guaranteed corporate loans, have been helping banks’ asset quality. What we typically see in a recession is credit card balances increase alongside delinquencies, as households run out of liquidity. This time around, the exact opposite has happened. Credit card data in the U.K. and in the U.S. showed that households have delevered, as stay-at-home policies and furlough schemes resulted in lower spending and higher savings ratios. From a balance sheet perspective, those dynamics weighed on revenues but clearly contributed to the resiliency of banks’ asset quality.
With higher capital ratios and stable asset quality trends, bank fundamentals improved through the course of last year, beating our already optimistic expectations over the resiliency of the sector in the face of a recession. Banks are not only supported by a decade of unabated balance sheet de-risking but have also benefitted from unprecedented policy interventions and regulatory relief measures.
Q: Bank fundamentals have remained surprisingly strong. Yet, certain parts of the bank capital market have lagged in the recovery. What are your thoughts on the market reaction and recent price developments in bank capital?
Bodereau: With the exception of March and April, when markets were heavily dislocated and not functioning, bank credit remained fairly resilient in the context of the violent contraction in GDP. In the case of senior bonds, valuations have already fully recovered from the widening in spreads experienced in 2020. In regards to subordinated bonds more junior in the capital structure, such as AT1s, while the market rebounded sharply from the drawdown episode, the recovery in spreads has been slower and lagged other areas of the corporate market. While AT1 spreads have continued to tighten year-to-date and have now largely recovered, AT1 bonds remain approximately 100 basis points (bps) wider than their 2020 pre-pandemic levelsFootnote4 and approximately 70 bps wider relative to high yield bondsFootnote5, which traded in line with AT1s prior to the pandemic.
We attribute the relatively lagging recovery in AT1 spreads to technical factors, with larger inflows and direct support from central banks in favor of corporate credit markets (at times also via direct bond purchases), which benefitted non-financial investment grade and high yield bonds more than bank debt, which is not part of central bank purchasing programs.
As discussed earlier, the banking sector is in remarkably good shape in light of the current economic environment. While the common belief is that the AT1 market would be disrupted through the course of a recession due to regulatory risk and potential losses from coupon-skipping and trigger events, none of those risks materialized last year. For a long time, AT1 bonds traded at a higher yield relative to generic high yield bonds despite the better average rating of AT1s precisely as a compensation for those risks. We expect that to change going forward, as investors will gradually start to acknowledge banks are a much safer and more defensive sector than they used to be.
The European AT1 market is represented by the Bloomberg Barclays European Banks CoCo Tier 1 Index (USD hedged); the Global High Yield Index is represented by the ICE BofAML BB-B Developed Markets High Yield Constrained Index (USD hedged).
Ratings are based on the higher of Fitch, Moody’s, and S&P for each individual issue in the index.
Q: Moving to the capital securities strategy that you manage, how did you navigate 2020? Have you made any significant positioning changes?
Bodereau: We were positioned quite defensively ahead of the sell-off, with an allocation to AT1s at the lower end of its historical range and a sizable portion of the portfolio in a combination of senior debt and liquidity. Following the drawdown last March, we first deployed liquidity into low-risk trades in senior bonds, which had underperformed due to liquidity dislocations and, as a result, were offering the best risk/return profile across the capital structure in an economic environment that was still highly uncertain. Valuations in senior debt normalized relatively quickly, and as the AT1 primary market reopened in May we rotated the portfolio into AT1 bonds by adding attractively priced new issues. As is typical with bonds issued following volatile periods (e.g., Q1 2016, Q4 2018), last year’s vintage of new issues featured higher reset spreads compared to previous vintages.Footnote6 Higher reset AT1s help investors mitigate potential extension risk, as those bonds tend to pick up less duration in periods of sell-offs and spread widening, making issues in the primary market the most favorable way to add exposure to the sector during 2020. We therefore re-risked the portfolio throughout 2020 and ended the year with an allocation to AT1s at the high end of its historical range, which contributed to a strong rebound in the performance of our capital securities strategy during the second part of the year. Going into 2021, we took advantage of market strength to take some profit and raise dry powder while remaining positioned relatively risk-on in light of our cautiously optimistic outlook and constructive view on the asset class, particularly relative to generic corporate credit markets.
Q: Pivoting back to bank fundamentals, what is PIMCO’s outlook for the sector, particularly with respect to the risk of nonperforming loan (NPL) formation? Additionally, should creditors be worried about shareholder distributions now that regulators lifted the ban on dividends and buybacks?
Loriferne: We are currently seeing banks in the U.S. reversing back part of the loan loss provisions taken last year, reflecting an overly cautious stance taken in 2020. European banks took a less aggressive approach at the early stage of the pandemic and continued to top up provisions last quarter in light of additional lockdowns weighing on the macro outlook. Generally, banks have focused on protecting their balance sheets, and have taken advantage of outsized trading gains to provision further when deemed appropriate. Meanwhile, NPL levels remain very low – on average, low single digits in Europe, and unchanged since the start of the pandemic. Debt moratoria increased to over 20% in mid-2020 but subsequently dropped to low single digits for most European countries as households de-levered or were able to restart payments as planned, again due to government support schemes. Those trends point to a relatively moderate increase in aggregated NPLs during 2021 – very manageable in the context of banks operating at historically high capital levels and with buffers to coupon-skip now at over 450 bps, on average, in Europe.
On the back of such strong capital positions, banks have now been allowed to restart dividends and buybacks, but those will remain very modest in size and, therefore, not a source of concerns for creditors. As an example, the European Central Bank is allowing banks to pay only the lower of 20 bps of capital and 15% of cumulative profits in 2019 and 2020 (net of any distributions). In notional terms, that is equivalent to distributions lower than €10 billion across the major European banks, against over €400 billion of excess capital available above regulatory minima. The resumption of dividends will not affect banks’ credit quality, but it provides a strong signal of confidence from regulators and can contribute to a recovery in banks’ equity valuations with benefits across banks’ capital structure.
Q: What are the key swing factors that could lead to more volatility in bank capital during the months ahead, and what is the impact of the ongoing surge in bond yields on the sector?
Bodereau: Idiosyncratic risk is low within the sector, with volatility more likely to come from broad macro events, such as delays in the distributions of vaccines and extended lockdowns, rather than single-name stories within the banking sector. AT1 bonds in particular are relatively high-beta instruments and, therefore, subject to changes in broad market risk sentiment. At a micro level, we see select opportunities driven by mergers and acquisitions and consolidation trends within the sector, particularly at a domestic level within peripheral countries, with upside offered by bonds of target banks.
It will also be important to monitor where rates go, given their impact on bank fundamentals. Higher rates and, in particular, steeper curves contribute to higher interest margins, benefitting bank fundamentals. And while increasing yields weigh negatively on returns of traditional bonds, including senior bank debt, AT1s are less sensitive given their callable structure with coupons reset at call date. We can look at previous periods of rising yields, such as late 2017 and early 2018, when 10-year U.S. Treasury yields increased by approximately 70 bps in a six-month period amid fears of higher inflation and earlier-than-expected hikes in interest rates. At that time, senior bonds generated negative returns, while AT1s outperformed, with short-call AT1s (callable in three years) performing best given their lower duration. Similarly, year-to-date AT1 bonds were up 0.86% (as of 28 February 2021, based on the Bloomberg Barclays European Tier 1 USD Hedged Index), despite a 49 bps increase in 10-year U.S. Treasury yields, as the impact from tighter spreads drove positive returns.
While our view is for a gradual increase in rates and curve steepening, bank fundamentals could benefit from an environment where markets continue to romance a reflation theme with a more rapid increase in yields, which would favor the ongoing recovery in bank equities with a positive impact across the capital structure.
All investing involves risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.
The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.
The Bloomberg Barclays European Banks CoCo Tier 1 index is a multi-currency standalone benchmark that tracks the market for contingent capital securities issued by european banks. For index purposes, contingent capital securities are defined as hybrid capital instruments with explicit equity conversion or writedown (full or partial) loss absorption mechanisms that are based on an issuer’s regulatory capital ratios or other solvency/balance sheet based triggers. The ICE BofA BB-B Rated Developed Markets High Yield Constrained Index tracks the performance of USD, CAD, GBP and EUR denominated below investment grade corporate debt publicly issued in the major domestic or eurobond markets. Qualifying securities: 1) are BB-B rated based on average of Moody’s, S&P and Fitch; 2) have a developed markets country of risk. Index constituents are market capitalization weighted and issuer exposure is capped at 2%. It is not possible to invest directly in an unmanaged index.
Beta is a measure of price sensitivity to market movements. Market beta is 1.The option adjusted spread (OAS) measures the spread over a variety of possible interest rate paths. A security's OAS is the average earned over Treasury returns, taking multiple future interest rate scenarios into account.
FX carry is the additional yield deriving from the hedging of currency risk. When investors wish to hedge a foreign currency exposure, they implicitly pay the foreign cash rate and receive the domestic cash rate (known as covered interest rate parity). When the foreign currency exposure is in a lower interest rate currency, the FX hedging activity typically results in a positive yield impact. In addition to the short-term rate differential, also the FX/currency basis stemming from demand and supply imbalances may affect the FX carry. When the FX carry is negative, it is typically referred to as hedging cost.
Yield to worst is the lowest potential yield that can be received on a callable or putable bond absent a default.
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