European banking M&A benefits bondholders

Back in May we highlighted that domestic mergers and acquisitions (M&A) activity was gathering pace in the European banking sector. In the UK, Nationwide was pursuing a deal for Virgin Money and Coventry Building Society was looking to acquire The Co-operative Bank, while in Spain BBVA had approached Sabadell for a possible merger (the latter has since become a hostile takeover). As we argued at the time, these domestic transactions presented limited execution risks and significant upside for bondholders of the entities being acquired.

Now we are seeing the first major cross-border M&A activity in Europe in a long time, with Italy’s UniCredit having built an equity stake of around 21% in Germany’s Commerzbank and seeking authorisation to increase it to 29.9%. Any merger or takeover – still some way off – would create a banking group with a market capitalisation of around €85bn, still behind the likes of HSBC (€150bn) and UBS (€96bn) but ahead of national champions BNP Paribas (€72bn) and Santander (€71bn). The transaction would also strengthen UniCredit’s position in Germany and move the franchise away from its home market, which could have a positive impact on UniCredit’s credit ratings.

This building trend of consolidation in the European banking sector has partly been provoked by higher interest rates, which have had a divergent impact on the fortunes of individual players. Banks with a more significant share of transactional, cheap deposits that were geared to higher rates benefited the most. Other jurisdictions where loans tend to have longer maturities and are repriced far slower have underperformed. This dispersion has created fertile ground for M&A activity, and UniCredit has found itself in pole position with its shares nearly quadrupling in value since the European Central Bank began its rate hiking cycle in July 2022.

This M&A activity is important for several reasons, and it could create further opportunities for bondholders.

First, the process naturally leads to stronger players acquiring counterparts who have tighter margins. This helps to reduce tail risks associated with the presence of these banks that may struggle to meet their cost of capital and instead they now benefit from cheaper funding as part of the larger entity.

Second, more specifically related to the UniCredit-Commerzbank transaction is the symbolic importance of the move in the context of the broader effort to create closer banking union in Europe. In the environment of weaker profitability and lower rates that followed the sovereign debt crisis, many European banks retraced from foreign jurisdictions and focused on their home markets. UniCredit is moving clearly against this trend and instead strengthening its existing operations in Germany. The move, if successful, could certainly embolden other players to contemplate similar activity and bring cross-border European banking ties ever closer.

Finally, and perhaps most importantly for bondholders, the ongoing M&A activity has added to already strong performance in the credit markets so far this year. Indeed, the bonds of the aforementioned takeover targets – Virgin Money, Co-op Bank, Sabadell and Commerzbank – have all clearly outperformed the broader market since the news of their respective deals became public.

Taken together, we welcome the M&A activity we have seen so far. We believe all these deals will leave the European banking sector on a stronger footing, while at the same time providing potentially attractive returns to creditors. Going forward, we would not rule out further activity and further upside for the bondholders of any new takeover targets.