The Great Bank Reversal of 2016
March 10, 2016
The Bank sector has experienced a reversal of its strong relative performance vs. the Corporate Index during the first quarter of 2016. In this white paper, AAM’s bank analyst examines the drivers of performance in the sector and looks at trades that have outperformed during the recent volatility.
In fiscal year 2015, the Bank sector was one of the best performing subsectors of the Barclays Capital U.S. Corporate Investment Grade Index (“the Index”), reflecting strong capital, improving asset quality and expectations of an impending rate hike cycle.
This trend reversed abruptly in the first two months of 2016 with banks participating in the sharp acceleration of negative excess returns in the Index. As of February month end, the bank sector had generated year-to-date negative excess returns of -227 basis points (bps) as compared to -248 bps for the Index. While broad corporate bond performance has retraced some of this performance in March, the bank sector has actually lagged the overall Index, having generated 40 bps of positive excess returns month-to-date vs. 94 bps for the Index.
However, a more granular examination of the performance in the bank sector better illustrates what trades have helped or hurt performance in the space. If we break out performance of senior bank bonds vs. subordinated bonds (the latter representing the riskier portion of the bank capital structure), it quickly becomes clear that the bulk of the negative excess returns were driven by the subordinated bonds (-498 bps through February). In contrast, senior bank bonds actually outperformed the Index with negative excess returns of -163 bps through February (Exhibit 1).
Source: Barclays, AAM
Additionally, the performance in the bank sector has been depressed by the non-domestic (Yankee) banks (-203 bps excess returns YTD for Yankee banks vs. -186 bps for banks overall). The negative performance in Yankee banks was driven in particular by the sharp sell-off in European banks in February as fears about capital adequacy and the ability to continue paying coupons on capital securities were sparked by poor financial results and diminished return on equity prospects for several of the continent’s largest banks (Deutsche Bank, Credit Suisse and Unicredit were all subject to material sell-offs).
Anecdotally, many total return managers were also hurt by their overweighting of Additional Tier 1 /Contingent Convertible (CoCo) securities, which represents an investment in the most junior layer of the bank capital structure. While CoCos are not included in the Index (because they are generally not investment grade rated), they generated very strong performance in fiscal year 2015 (+6.3% total return), and were a top recommendation of most sell-side credit strategists heading into 2016. However, through February AT1/CoCos delivered a -8.6% total return as fears about coupon sustainability grew.
So how is AAM positioned within the bank space?
We have been overweight the bank sector since mid-2009 based on improving fundamentals and an increasingly benign economic outlook. However, within the bank sector we have retained a strong preference for senior vs. subordinated bonds, reflecting a preference for downside protection and a desire for clarity on Total Loss Absorbing Capacity/Capital (TLAC) rules. We have also increasingly weighted regional and community banks vs. universal banks, reflecting the potential for increased issuance by universal banks to meet TLAC minimum debt requirements, as well as our view that the traditional banking model of the regional space was likely to have better fundamental momentum in a slow growth environment and less residual regulatory liability.
Finally, we have been underweight Yankee banks, and particularly European banks, since macro-political instability in Greece, Italy and Spain sparked the European sovereign crisis in 2011. Although fears of a Euro or EU break-up have receded somewhat, we have remained underweight as we feel the underlying causes of that crisis (lack of political consensus and stagnant economic growth) remain unresolved. Additionally, we view the European universal banks as having a much greater restructuring burden with regard to meeting TLAC requirements as compared to the U.S. universal banks.
While our underweight to subordinated debt and Yankee banks constrained investment performance during 2014 and 2015, the benefits of this credit selection can be seen in the downside protection in periods such as the first quarter of 2016. Conversely, we began selectively investing in subordinated bank debt of the U.S. universal banks in late February, as we felt that the spread widening over the previous two months had made certain credits attractive given our fundamental outlook (Exhibit 2).
Source: Barclays, AAM
For more information, contact:
Colin T. Dowdall, CFA
Director of Marketing and Business Development
Vice President of Business Development
Vice President of Business Development
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