Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
European banks are under pressure as funding costs soar
Peter Garnry
Chief Investment Strategist
Summary: In today's equity today we focus again on European banks which are down 5% led by Deutsche Bank as CDS prices have getting repriced higher and AT1 bond yields sit at 12% far exceeding the return on equity. This means that the AT1 capital market is at this point not a viable funding source for banks and thus common equity must be raised over time which will be dilutive for shareholders. The banking crisis is far from over and the impact on credit conditions and the economy will likely be felt over the next six months.
AT1 bond yields surpass return on equity
European banks are down 5% in today trading with Deutsche Bank leading the declines following a big jump in its 5-year CDS price. Not even redeeming a tier 2 bond despite fears of calling the bond is enough to calm the market. European real estate stocks are also down 2.3% with Aroundtown leading the declines hitting an ultra-low price-to-book ratio of just 0.15 which means essentially that the market is afraid that the company can go bankrupt. Aroundtown has €40bn in real estate assets and €15.6bn in debt. If the real estate sector continues to slump then it could be the next amplifier of risk for banks and the overall market.
Also adding to the negative sentiment is the news this morning that Deutsche Pfandbriefbank AG (PBB:xetr) has decided not to call one of its AT1 bonds citing financial conditions and costs. Not calling the bond means that the coupon resets from 5.75% to 8.45% which 270 basis points increase in the funding costs on that part of the tier 1 capital structure. The AT1 bond market was already weak post SVB, but the shotgun wedding between UBS and Credit Suisse wiping out the AT1 capital holders, which was legally okay according to Swiss law, causing a significant jump in the AT1 bond risk premium to the government bond curve. AT1 bonds are down 22.7% from the peak in early February (see chart below).
The problem for European banks is that median AT1 bond yield on the bonds in the Invesco At1 Capital Bond UCITS ETF around 12% which far exceeds the return on equity (ROE) which in the past 12 months has been 9% and since early 2010 the average ROE has been ~4%. This means that the AT1 capital market is now not a viable funding source for tier 1 capital and thus common equity is now in play. The issue is that European banks have delivered only 2% total return over the past five years and thus the equity story is not very attractive. But they will need to replace AT1 bonds with common equity, even the ECB said last year that they want banks to be less reliant on AT1 capital, which will be dilutive for shareholders. This is what we now see being reflected in European banking stocks. Effectively the banking trade in Europe has its attractiveness.
Putting it all together funding costs for banks are on the rise and thus interest rates into the economy will go up which in turn will tighten credit conditions and increase the likelihood of a recession. As soon as this logical chain is understood by the equity market it will stop treating falling yields as a panacea but as a sign of bad times ahead.
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