5 Min Read
* Improving capital base to lure traditional investors
* Sub financials to provide attractive returns vs high-yield
* Investors to remain picky as ECB bank review gets underway
By Helene Durand
LONDON, Jan 24 (IFR) - European institutional investors are returning to the hybrid bank debt market, spurred on by a better outlook for banks, a search for higher returns, and a lack of attractive alternatives.
Many investors were put off the sector after suffering painful losses during the financial crisis, and baulked at tough loss-absorbing features included on new deals designed to ensure taxpayers do not have to rescue institutions.
However, as European banks prepare to sell what Citigroup estimates will be around EUR248bn of Additional Tier 1 and EUR266bn of Tier 2 to meet capital requirements imposed by CRD4, investors are looking to change their stance.
Since BBVA priced the first deal in May 2013, the proportion of hedge funds and private banks in Additional Tier 1 issues has gradually shrunk in favour of insurance companies, pension funds and asset managers.
"The new wave of CoCos will be coming at the right time," said Daniel Bjork, senior portfolio manager at Swisscanto asset management.
The participation of traditional investors will likely be boosted further after the creation of a CoCo index by Bank of America Merrill Lynch at the end of last year
European banks' improving story plays a strong part in the increased attractiveness of the market.
"This is still a sector that is deleveraging and we believe will continue to do so in the coming years," said Satish Pulle, lead portfolio manager at ECM Asset Management.
Assets at more than 250 banking groups and credit institutions across Western Europe have shrunk by EUR34trn since 2009, according to Morgan Stanley analysts,
"Banks have made a lot of progress, assisted by central banks and regulators, and Common Equity Tier 1 ratios have improved," added Andrew Jackson, chief investment officer at Cairn Capital.
According to the Morgan Stanley note, the average Core Tier 1 ratio across the same set of banks has climbed to 12.4% this year from 11.1% a year ago.
As well as improved balance sheets, the amazing returns received on old-style instruments - by those bold enough to have invested in them at the height of the crisis - are undoubtedly helping too.
Steve Logan, head of European high-yield at SWIP, said that in 2012, returns for fallen angel financials were 45%, versus around 28% for high-yield.
Positive sentiment and a dwindling stock of old-style deals, which have either been called or bought back, have been behind the positive momentum.
In early January, Cairn Capital announced that it had closed its subordinated financial fund launched in October 2011 after posting returns of 65%.
Investor focus is now shifting to the new asset class, and those who entered early have reaped the rewards.
Swisscanto's Bjork cited the example of Credit Agricole's high-trigger Tier 2 CoCo launched in September last year, which has produced a total return of 14% since pricing.
Michael Hünseler, head of credit portfolio management at Assenagon, which launched its Credit Sub and CoCo Fund at the end of 2013, said that last year's almost double-digit returns will be to hard to repeat. "Having said that, we view CoCos as attractive and expect returns in excess of the running yield."
Hünseler and other investors expect base returns of around 4.5%, and an extra 1% to 2% on the back of the positive market backdrop and active portfolio management.
ECM's Pulle and other investors agreed that banks were still paying a complexity premium for CoCo issuance.
"Unlike the corporate high-yield sector which has become low yield, financial issuers are still paying reasonable premiums and yields are still attractive," he said.
Investors are clearly warming to the asset class, but the ECB's review of the eurozone's largest banks and upcoming stress tests suggest there are risks ahead.
As Cairn's Jackson points out, while Common Equity Tier 1 ratios have risen, it is questionable whether there has been any significant improvement on the asset side of balance sheets.
"The NPLs in Spain and Italy are still pretty alarming," he said.
Meanwhile, SWIP's head of credit research, Laurent Frings, said the risk for the asset class now was more technical. "There is potentially a lot of supply coming," he said.
This could be the trigger for a correction in a market that has rallied hard since the end of last year.
"These instruments will be more volatile when the market is in risk-off mode, but the coupons being paid give much more of a cushion and room for error and the best volatility-adjusted returns," said SWIP's Logan. (Reporting by Helene Durand, editing by Alex Chambers, Julian Baker)