CoCo Re-rating Underway as Euro Banks Prove Mettle

With the earnings season in full swing in Europe, it is interesting to see the impact the gradual economic reopening is having on various sectors. One area where results have been almost unambiguously positive is the banking sector, where excluding those banks with idiosyncratic issues, results have continued on the broadly positive trend seen since the initial COVID-19 lockdowns.

European and UK banks have so far echoed the positive tone from the US banks earlier this month; by-and-large they have beaten consensus expectations across the board on earnings, provisions, capital ratios and forward guidance and reinforced the resilience they displayed in the depths of the global pandemic.

This morning it was Deutsche Bank, an institution that has struggled to find its footing since the global financial crisis, leading the way with impressive earnings. The German bank posted its best quarterly results in seven years, beating guidance in practically every area, which on top of having successfully navigated the Archegos fallout has given a timely boost to its investors. Other banks releasing impressive looking results this morning included the UK’s Lloyds, Denmark’s Danske Bank, Sweden’s SEB and Spain’s Santander, showing the robustness of banks across a number of geographies. 

Having been at the heart of the GFC and then contributing to the Eurozone sovereign crisis, we have long argued the European banking sector would have to prove its newfound resilience to investors by successfully navigating a challenging period. Following the global pandemic and economic shutdowns, the strength of these banks and the robustness of their balance sheets has certainly not gone unnoticed; we are seeing new investors attracted to the sector and we think a re-rating of bank debt is underway, with CoCo bonds among the top performing credit sectors in fixed income in recent weeks. This month alone the ICE BofA COCO bond index spread has tightened by 28bp, well ahead of the 11bp of tightening enjoyed by the equally rated and similar duration BB high yield index, and the 3bp of tightening in the BBB index (also similar duration).  

How far might this tightening go? Before the GFC, hybrid Tier 1 bonds – the precursor to AT1s which crucially did not have a write-down trigger – traded as tight as 100bp over the risk-free rate. It is difficult to argue that AT1s should ultimately trade at similar levels, but the 300bp spread over risk-free on the CoCo index currently looks too high to us. We certainly expect the tights of the last cycle, the 250bp achieved in January 2018, to be beaten given the increase in credit quality and ratings we have seen for European banks since then, and the new lows for spreads in our opinion could be significantly tighter.