Investment in a Minute - Re-engaging with non-senior financial bonds

Where do you think opportunities are most underrated and why?

The large market gyrations we have seen this year within fixed income have opened up what we believe are a few significant market dislocations. One such opportunity that we have identified within the credit markets relates to non- senior financial bonds, which we consider as highly attractive.

From a fundamental perspective, many banks still carry today some of the stigma from the 2008 global financial crisis, although the picture is quite different in our view. While banks would of course not be immune to a severe economic downturn, we believe they are now on average much better capitalised and managed in a much more prudent manner than was previously the case. In Europe for example, from 2015 to 2022 the Common Equity Tier 1 (CET1) ratio for European banks increased from around 12% to 15.5% on aggregate, and non-performing loan ratios declined from 8% to 2 over the same period, according to the European Central Bank.

In addition, banks have also been benefitting from the current higher interest rate environment, through increased net interest incomes. We believe these uplifts to aggregate revenues should contribute substantially to offsetting some of the increases in loan losses that are likely to occur next year from lower economic growth.

If we add these factors to the attractive levels of valuations we are seeing in the bond markets, with for example lower tier 2 bonds trading at wide spreads vs BBB rated non- financial bonds, we believe investors should think about re- engaging with non-senior financial bonds, on a selective basis.

What’s keeping you up at night and what should investors be mindful of?

Over the next few months, I believe that inflation will continue to be a very important driver for bond markets. In this regard, the lower than expected October US inflation print was a welcome development for many investors, with bond and equity markets rallying on the back of the announcement. While it was a step in the right direction, we would advise against any hastened conclusions.

Indeed, just this year there have already been two occurrences where inflation surprised on the downside (0.3% MoM US Core CPI in March and July), only to bounce back quite strongly in subsequent prints. Looking at the longer term, the US Federal Reserve will also be mindful of the scenario that played out in the 1970’s, when headline inflation fell substantially in 1975 and 1976 (from 12% YoY to below 5%), only to rise again to above 14% by the first quarter of 1980.

In our view, these two previous episodes may help us to better understand the Fed’s reaction function today, and why according to Chairman Powell “the historical record cautions strongly against prematurely loosening policy”. Aside for a significant growth shock, the Fed is therefore likely to continue to err on the side of caution in relation to monetary policy.