Fundamentals show European banks well set up as bonds are still cheap

Whilst bank debt has recovered from the contagion of the US regional banking crisis and the Credit Suisse write down event earlier this year, many bonds are still trading wider than they were at the beginning of the year. This comes as fundamentals and credit ratings have improved throughout 2023. As we are well into the third quarter earnings releases, we take a look at the major trends seen in bank earnings and how they appear well set up at this stage of the cycle. 

The ECB was the last of the major Central Banks to start hiking rates and as a result we predicted that Eurozone banks would be the last to benefit from rising rates. This has proven to be the case as banks across the continent continue to show improving net interest margins (NIM). Yesterday, Spanish bank, Sabadell, reported a NIM of 202bps, increasing from 188bps the previous quarter, which in turn saw net income 21% higher than consensus. Meanwhile, the Bank of Ireland raised its guidance for net interest income at year end to be up by 5% from the first half.
 
Earlier this week, we saw similar trends from Santander with margins improving, however this was offset in part by net loan loss provisions increasing by 20% YoY. This conservative behaviour we think is prudent as investors continue to question whether higher rates will impact the asset quality of banks. Santander, however, demonstrates that banks are set up well to deal with this, as improving margins will be the first defence against any potential increase in loan losses. It is also worth noting that those banks which have increased provisions have done so as precautionary measure. Thus far, we have seen no actual signs of asset quality worsening at all, and in our conversations with management of banks are yet to see even lead indications that this is happening. 
 
In the UK, shares of Barclays fell after their Q3 earnings release - primarily on the guidance that margins had peaked. Whilst this may be a concern for equity returns, Barclays’ NIM guidance of 3.05-3.10% (down from 3.15%) is still very healthy and will continue to allow them to generate capital as protection against any future volatility. Indeed, from a fixed income perspective results were encouraging with bonds unchanged and CET1 increasing to 14%; leaving them a healthy buffer against their regulatory requirements which included an increase to the countercyclical buffer. 
 
Another interesting development in the earnings season so far has to do with the newly created tax on Italian banks. Recent Italian Government legislation gave banks an option to pay a windfall tax or increase non-distributable reserves. We believe this in principle to be sensible as it encourages banks to hold onto earnings, and once again it promotes that banks in their healthy state can be part of a solution of any potential slowdown that we may see. As a result, UniCredit this week set aside 1.1bn euros as reserves – however there were reports that UniCredit may buy a 9% stake in a Greek bank, and thus this policy may actually encourage Italian banks to simply acquire more assets. This is something we will continue to monitor. Nonetheless once again the strength in fundamentals at UniCredit is clear to see: CET1 at 17.19% (a buffer to requirements of almost 750bps), margins increasing and non-performing loans low and stable. These recurring themes are the reason that European bank credit ratings have seen positive momentum this year, with Moody’s awarding 4 upgrades for every downgrade thus far. UniCredit’s AT1 rallied by over a point after its results and yet it still yields over 13% in £ to the 2027 call, meanwhile its Tier 2 is trading at just below 9% in £ to the 2027 call.  
 
Banks’ fundamentals appear healthy, improving and well set for any potential slowdown. At these levels, bank bonds look an attractive proposition for investors to deploy some capital towards.