The financial sector accounts for anything up to 70% of many corporate bond markets – and opinions on the sector in general, and the new contingent convertible capital instruments (CoCos), in particular, remain polarised. 

In the US, spreads on industrial debt have dropped close to the lows last seen in 2005, and while bank spreads have also plummeted, there is further to go before they reach those pre-crisis lows. 

“Given the current market environment, I do not want to be overweight in risk assets, and particularly those parts of the market most exposed to the cycle – and that is still financials,” says Ben Bennett, credit strategist at Legal & General Investment Management. “While we have a self- fulfilling positive spiral in financials, it is just another confidence crisis away from revealing the reality beneath.” 

By contrast, many firms are now overweight the sector. AXA Investment Management, for example, has the view that the financial sector has been under such pressure to deliver that, certainly from a bondholder’s perspective, taking this position that makes sense.

“We have been as much overweight financials as we could because, after the banking crisis, the pressure on banks to add capital, improve liquidity and reduce risk on balance sheets has been very positive for bondholders,” says Anne Velot, head of euro credit.  “Core tier-1 capital for banks, for example, was at only 6% just before we entered the crisis. Now, it has almost doubled, on average, for European banks.” 

Neil Williamson, head of EMEA credit research at Aberdeen Asset Management concurs. “In general, banks have been in recovery mode for the past five years, having been in a near-death experience,” he says. “We would see the banking system as one that has been in significant and deep repair. There are still sick candidates – such as some of the German Landesbanks – that are still struggling to have a relevant and profitable business model. In contrast, banks such as RBS, what is left of Fortis, ABN AMRO, Lloyds and others have been in recovery and are looking substantially better.” 

Williamson acknowledges that investing in banks on the assumption that governments would always bail them out is not an option anymore – but the response has been a renewed focus on capital bases, regulation and becoming fit for purpose again.

At a glance 

• Opinions on the health of financial bond issuers are polarised.
• Some point to better capital ratios and the working-through of balance sheet problems from the crisis.
• Others point to the deeper, structural legacy of the pre-crisis global build-up of debt, and see apparent recovery as an illusion.
• US institutions are in the best shape, and within Europe, Scandinavia and the UK look best-positioned, with Italian and Spanish banks still struggling.
• If investors disagree on the fundamental health of banks, they disagree even more sharply on the suitability of their new forms of hybrid capital.
• The picture in non-financials looks very different – rather than de-leveraging, they are re-leveraging.

But for Bennett the recovery in the financial sector is just an illusion. “My core thesis for the crisis was that there was too much debt for the world as a whole, in both developed and emerging markets,” he explains. “Creating debt created asset bubbles in housing markets and allowed US consumers to consume too much, mirrored by too much investment in China. The debt issues that were at the core of the crisis have not been resolved, but alleviated by another round of issuance, with debt in China going ballistic, and huge amounts of debt creation in the emerging market local currency markets. So, looking deeper, we still have the same problems of asset price inflation and money creation leading to false confidence in systems.” 

The response to the tiniest ripples in risk appetite – like last year’s response to the Federal Reserve’s comments about tapering its QE programme – has consistently been to create even more money and debt, Bennett adds. He argues that this is ultimately unsustainable and that the next three to five-year periods of tranquillity will be interrupted by some realisation that a debt bubble has been created and capital has been misallocated, creating significant volatility.

Most would agree that European banks are likely to face more concerns than those in the US . 

“US banks have cleared a lot of their problems, although nasty bits of legislation are still there,” says Simon Hawkins, senior portfolio manager at Conning Asset Management. “On the other hand, European banks still have a number of unresolved issues in terms of how much of their non-performing loans they have cleared from their balance sheets.” 

The US banks are probably a couple of years ahead of where European banks would like to be, believes Andrew Fraser, investment director at Standard Life Investments

“Within Europe, the Scandinavian banks have been less touched by the banking crises, so they have seen higher rates of growth there. But, even so, their regulators are demanding much higher levels of capital,” he says. “We have found parts of the UK banking sector better, France is in the middle, while Italy and Spain still have significant issues. They are two of the markets with the best spreads across the capital structure, but they are still in the process of deleveraging and improving their balance sheets to be less susceptible to future risks.” 

Fraser prefers the subordinated parts of the capital structure because of the yield pick-up relative to risk. The risk of bail-in is priced into subordinated spreads but not necessarily into senior spreads, he observes. “In the worst-case scenario, senior bondholders could be bailed in, and recovery rates would be very low and that is not built into current spreads,” he warns. “Spread pick-up for one or two notches down in rating is very good.” 

CoCos have been introduced as a new subordinated tier of debt capital for the banking sector to provide a layer of risk capital. But they have proved to be a very controversial investment for institutional bond investors, who find many features unpalatable. 

Bennett is dismissive. “They are not really bonds,” he insists. “CoCos are an asset class that can be withdrawn at the whim of a regulator. That is a real line in the sand as to whether it is a bond or not and we will fight very hard for them not to be included in bond indices. They may look like a bond and have a call date, but there is no incentive to call and the coupons can be switched off without necessarily a reduction in equity dividend payments. If anything, they feel more like equity, which, as a senior bondholder, is good, as they will take a loss before us.”

Velot is much more receptive, however. She concedes that Cocos could be converted into equity very early into the deterioration of a bank, on the whim of a regulator, but she points out that even depositors faced that situation  at the Bank of Cyprus. Velot’s point is that an investor that buys a high-risk bond always runs the risk of becoming an equity holder. Banks are very leveraged, so there will always be risk in subordinated debt; it is there to provide risk capital and it is healthy that investors are now clear about what subordinated debt stands for. 

“We differentiate between names, rather than structures, as the structures are very complex and there is not much history of how they actually perform in a crisis,” explains Velot. 

Nonetheless, institutional investors, as a whole, have, so far, shied away from large commitments to CoCos, which have, instead, appealed to retail high-yield funds and hedge funds. The fact that yields have come down is also an issue. 

“The Barclays CoCos were issued at 7-8% but are now down to 6% – when you can get 4% on a high-yield index,” says Williamson. “I have no problem with banks issuing them, but investors need to know the risks.”

While the de-leveraging financial sector dominates the headlines, the story on the non-financials side of the corporate bond market has been re-leveraging and the return of M&A.  

“This has been more obvious in the US than in Europe where fears over the economic scenario are still holding corporate treasurers back,” says Jamie Hamilton, senior institutional credit fund manager at M&G Investments. “In the US, share buybacks financed by debt are increasing, with Apple being a recent example. When I see corporates leveraging themselves up on purpose, I am more comfortable. In the case of share buybacks, companies have control over what they are doing and even if they move down a couple of notches, there is less chance of distress. It is more of a problem when companies are becoming leveraged as a result of operating difficulties.”

The risk-reward profile of financial-sector debt is very different to that for industrial sectors. This can make straight comparisons difficult. Financial companies enjoy a lot of support that is not available to industrials but, of course, they are massively leveraged and tend to be more volatile.

“We require a higher yield for a BBB financial versus a similarly rated non-financial industrial company,” says Williamson. “The nature of the business model is very different. Banks put on assets and hope they are good. If they stopped trading tomorrow, and the assets are good quality, it would be fine for us as a bondholder. A corporate cannot stop trading without causing a major impact for bondholders. But the difficulties in the auto industry took 20 years to develop, whereas banks have a greater risk of falling off a cliff very rapidly. You don’t see runs on a supermarket. While rating agencies do as good a job as physically possible in producing comparable ratings for banks and industrials, they are fundamentally different animals.”

For institutional investors, taking a stance on the financial sector will be critical. But determining whether the underlying improvements in the banking sector really justify the huge reduction in spreads remains a tricky question.