Getting used to volatility

Bond markets have since mid-April been hit by unprecedented volatility – and, in the words of European Central Bank president Mario Draghi, everyone had better get used to it. Here, investors and Crédit Agricole CIB representatives share their views on what has been driving markets, how they have been coping with the turmoil, and what to expect in the months ahead.

Mario Draghi June 2015 presser

Filippo Alloatti, senior credit analyst, financials, Hermes Fund Managers
Dierk Brandenburg, senior credit analyst, Fidelity
Mariano Goldfischer, global head credit trading and syndicate, Crédit Agricole CIB
Craig Guttenplan, global credit analyst, Rogge Global Partners
Vincent Hoarau, head of FIG syndicate, Crédit Agricole CIB
Raphael Robelin, co-CIO, BlueBay Asset Management
Julien de Saussure, fund manager, Edmond de Rothschild Asset Management (France) (EDRAM)
Charles Sanford, co-head of investment grade corporate credit, Babson
Enrico Scarin, portfolio manager, Generali Investments Europe
Moderator: Neil Day, managing editor, Bank+Insurance Hybrid Capital
Participants kindly dedicated their time to responding to these questions in the week leading up to Friday, 26 June – the day the surprise Greek referendum was announced.

Markets have experienced a historical reversal in outright yields combined with an increased level of volatility – how do you explain this turnaround and its magnitude?

Dierk Brandenburg, Fidelity: I would say the main driver is the fact that the investors went long across all fixed income asset classes after the ECB announced QE, including government bonds as well as AT1. The trade unwound as expectations on growth and inflation changed. On top of that there were renewed concerns about Greece that affected risk premiums. These price moves were then exacerbated by the increasing regulatory constraints on market-makers that contribute to poor secondary market liquidity.

Enrico Scarin, Generali (pictured below): The turnaround we have been seeing in core real rates has been triggered by a sudden repricing of growth and inflation expectations. However, we believe this fundamental factor was only the trigger for a correction that went well beyond investors’ expectations, if not for the absolute movement, for its extreme rapidity. We can only explain such a spectacular drop in fixed income prices with the concurrent unwind of what we can label “the QE-trade”, that is the fact that many investors had positioned short euro, long duration, long European risky assets in anticipation of the ECB monetary policy.


Filippo Alloatti, Hermes: The recent repricing in euro area government bonds can be explained by a number of factors: market levels reconnecting with history/fundamentals, as some quarters were expecting ECB sovereign QE to depress sovereign yields for ever; rising inflation expectations, with the inflation swap five year now at 1.7%; a modest euro area CPI inflation surprise; the cyclical recovery gaining momentum; and a less-than-optimal liquidity environment exacerbating the moves.

Raphael Robelin, BlueBay: The best analogy for what happened in all markets that I can think of is an elastic band that you keep pulling and pulling, and eventually it snaps — extreme valuations that had gone so far they eventually proved unsustainable. There are then two interesting observations one can make about what happened.

Firstly, there wasn’t a particularly obvious catalyst for the sell-off. You didn’t have, for example, a particularly surprising economic data release, or a change of tune by the central bank, or anything major that could explain a fundamental shift in the market assessment.

The other interesting observation is about yields. Nominal yields really have two components: you have the real yield you are being paid, and then the inflation expectation. Now we have a pretty efficient way to measure the latter because you have an inflation-linked market in the Eurozone that is quite liquid, so we know how to decompose a nominal yield between the real yield demanded by the market and the inflation expectation over the corresponding period. And what is quite interesting to me is that inflation expectations have not really moved during this sell-off. So it is really the real yield demanded by the market that went from very extreme negative levels to still negative but less extreme levels, and it is this change in term premium or in the real yield demanded by market participants that really explains the back-up in yields. The way I think about this is that, looking at other jurisdictions where QE was implemented, the market eventually becomes more confident that QE can work, and that the central bank will be somewhat successful at fighting the deflation risk and engineering a bit more inflation in the system. Even though bonds are the very asset class that is being used by the central bank to ensure this outcome, nevertheless, because there is a higher conviction that over time the economy is going to be OK and maybe deflation will be avoided, that typically leads to a somewhat higher yield — that was the case in the US during the QE period and it was somewhat the case in Japan, as well.

Vincent Hoarau, Crédit Agricole CIB: Markets have gone too far and too fast and got ahead of themselves in anticipation of the full scale QE. The situation was not sustainable anymore and this became obvious when yields were negative nearly everywhere in low beta instruments at the front end of the curve. Draghi offers a quasi-unlimited backstop bid in secondary and, driven by regulatory constraints, many market participants got engaged at outrageous levels in low betas believing in easy capital gains in negative yield territory. Elsewhere, everyone was long duration while convergence was going on in senior and in the subordinated spaces.

The catalyst for the sharp correction emerged in April. Inflation figures released in Europe were much higher than expected, implying the deflation scenario was off table and (low) growth around the corner. This triggered shifts in directional positions and the reversal of “QE trades”. At the very same time US GDP figures showed evidence of a slowdown in the recovery and the US dollar sold-off versus the euro. There was a clear change in the perception of the macroeconomic environment and this caught everyone by surprise. It marked the start of the strong back-ups in rates combined with the return of great volatility. The resurgence of the headlines on Greece — which were even foreseeable — just exacerbated the situation. To cut a long story short, people don’t trade on liquidity parameters anymore but fundamentals. This is a major change.

How do you manage the current situation and what are the greatest risk factors ahead of us?

Scarin, Generali: Even if one had rightly anticipated a correction in rates, the ability to effectively position in that sense has always been limited, especially for institutional investors with absolute return mandates or legal liabilities to cover, who struggled to satisfy their targets and had no choice other than balancing higher duration, higher credit and liquidity risk. Effectively what helps you as an investor in these cases is the ability to diversify your sources of yield enhancement, and the recent episode was no different in that sense.

Going forward, key risk factors are Greece and growth dynamics in Europe; I would also add that another strong leg down in fixed income prices could trigger some outflows out of the asset class towards equities and less interest rate-sensitive assets such as credit, where risk premia are attractive only in specific sub buckets.

Robelin, BlueBay: The first point to make is that we have had a negative bias on the outlook for interest rates and therefore the beta in core fixed income for a while now. We really felt that valuations had become very artificial and that we almost had a giant Ponzi scheme developing: you can’t really buy a 10 year Bund at 0.1% and think that you’re making a sound investment; the only reason you’d buy it is either because you’re forced to for regulatory reason or as a more mark to market focussed investor because you believe that you’re going to be able to sell it to someone else at a higher price.

And so we have been great believers at BlueBay that the kind of beta opportunity in core fixed income is being challenged, and so over the last few years we’ve been launching kind of next generation fixed income funds for our clients that really try to generate some absolute return without much beta risk. So we really try to identify market inefficiencies and investment opportunities in the market without having a bias towards having a lot of beta, and so certainly with very little if any interest rate duration exposure because we felt that the value proposition in core rates was indeed very, very poor.

That being said, we were somewhat taken aback by the rapidity of the sell-off. We were also somewhat surprised by the fact that during the last ECB press conference Mr Draghi basically told market participants that the ECB was happy to look through the period of volatility, and that to them volatility was a kind of pretty rational consequence of the very low rate environment and that market participants basically had better get used to it – even if many market participants, like us, felt that it was counterproductive in going against the central bank’s aims under QE.

Regarding the consequences for credit, you know, the more volatility you have, in particular rates volatility, the more risk premium you should demand. So while we started the year with a pretty bullish view for credit spreads, it has been our opinion over the last two months that — what with the heightened interest rate volatility, the uncertainties around Greece, and the uncertainty around the timing of the first US rate hike — when credit spreads in Europe reached 90bp and when the CoCo index was at more than 6% over the first four months of the year, we came to the conclusion that a lot of the upside was now gone and that the right thing to do was to book some profits and move our portfolios to a more neutral position. So that is something that we did over the course of the second half of April and the month of May.

Mariano Goldfischer, Crédit Agricole CIB (pictured below): Overall the level of volatility has increased significantly in the Eurozone not only due to the Greece situation but also due to the repricing of the “risk free” curve in government bonds (Bunds). On top of that, the regulatory changes and associated capital cost have an impact on the dealers’ ability to warehouse inventory, impacting the liquidity of the market and the ability of investors to shift risk. We strongly believe that some of the structural changes in the market are here to stay, and that the lack of liquidity as we used to know it will be the major impact on the market. In this environment, allocations of scarce resources will be fundamental to service the client base.

Mariano CACIB

Brandenburg, Fidelity: To put it simply, our funds held more cash and thus didn’t buy as many securities as we would otherwise have done. That view may change if volatility in government bond yields recedes and the Greek situation is resolved.

How long can the market afford to wait for clarity on Greece? Are you prepared for Grexit?

Alloatti, Hermes: At the time of writing, the market is paying quite a bit of attention to the headlines tennis – deal/ no deal – around the protracted Greek negotiations. We have observed a few deals in the financial space being pulled in the last few weeks, some – and understandably so – in the subordinated space.

We tend to think a “rational outcome” would call for an agreement to be found somewhere in the middle. We are cognisant of the counterparties’ different red lines and the need for a new DSA (debt sustainability analysis) from the IMF. We never thought the road to an agreement was going to be smooth. Assuming a compromise of some sort is reached, the market may remain Greek-headline-dependent for a while longer. This would be a kick-the-can-down-the-road type scenario implying a day-by-day market. Other scenarios include a self-explanatory nuclear one, and an excellent one (sadly unlikely) where everything is sorted.

The direct effect of a worst case scenario should be limited to Greek banks — which by the by were not the cause of the country’s difficulties. The second-order effect is nigh on impossible to calculate in advance. Sub financials and peripheral banks are for good and bad reasons often associated as transmission mechanisms for contagion.

Scarin, Generali: The situation in Greece will continue to create volatility and uncertainty because there is no parallel in financial markets’ history of a currency union breaking down in a developed market such as the European one. As such, I do not believe someone can effectively feel “prepared” for such an event.

On the positive side, an accident on the Greece front is not unexpected anymore, and the effects should be more contained than one could have feared some months or years ago. Moreover, it is very important to distinguish between short term market volatility and longer term market reaction. One cannot exclude that the euro area effectively comes out stronger than before after the “existential crisis” the Greek situation is causing.

Brandenburg, Fidelity: Yes, we are fairly optimistic that politicians will want to avoid a big negative market event such as a Grexit. However, the economic weakness and political uncertainty in Greece will persist for some time.

Is the time right for the reopening of the market?

Brandenburg, Fidelity: Yes, absolutely. We have seen it with new Lower Tier 2 and bank senior issuance this week, so that’s already happening, and we expect more. We anticipate a last wave of supply before the summer.

Because of the volatility in the market supply was rather less than we had expected. I think there were other banks actively looking at AT1, such as RBS, so we still expect those to come.

Robelin, BlueBay: If we look again at the three key risks I mentioned — the rise in interest rate volatility, the Fed, and Greece — I would definitely say that since we decided to reduce the credit risk in our portfolios valuation have clearly moved wider and the compensation reflecting these risks is in our opinion more appropriate than was the case in early April. And each one of these risks we would argue has somewhat receded.

The Fed obviously was in our opinion quite meaningfully more dovish at its latest meeting — not only somewhat delaying the likely timing of the first rate hike, possibly to September, more likely to December. And they were also very vocal in saying that not only will they take time before the first rate hike, but they also intend to be extremely gradual in the way they will raise rates when they start raising. So it is difficult to foresee much chance of a big surprise in terms of the pace of rate hikes from the Fed and the timing of the first hike. So that is one concern that, while not taken out of the equation, is certainly somewhat delayed.

And if you look at rates volatility, you have this Fed outlook but also valuations are now far more appropriate — around 90bp for the 10 year Bund. You’ve got your five year-five year swap rate in the Eurozone at about 2% now, which we think is not cheap but maybe a fairer valuation, and therefore one that will provide some kind of valuation anchor to interest rates in the Eurozone, which we didn’t have 100bp ago. And so we do expect interest rate volatility to somewhat come down over the summer.

And then in Greece, it was our strong view based on our meetings with the Greek government that there was almost an even chance of a Greek default and capital controls being implemented in Greece over the summer. With Prime Minister Tsipras’s decision to call for a referendum, and the expected announcement of restrictions on capital flows, we expect Greece to remain a source of volatility in the short term.

Notwithstanding the uncertainty around Greece, we remain positive on the medium term outlook for European credit spreads, given sound credit fundamentals, reasonably attractive valuations, and our expectation that demand for credit will remain strong in a low interest rate environment where investors need incremental spread. However, we are happy to be patient and wait for opportunities to buy bonds at attractive levels, either from distressed sellers in the secondary market or via new issues. We know there is plenty of supply looming, and we believe that this supply will have to come at attractive levels — the first ABN Amro Tier 2 was a good reflection of that and we had HSBC coming to market with a decent concession as well. That is one of the other reasons we were quite comfortable selling cash bonds in April and May, because we were convinced that with the amount of supply waiting on the sidelines that – even if we were wrong about the outlook for spreads and even if they didn’t widen — we could put this cash back to work in the primary market on pretty good terms.

Would a last minute solution on Greece change your view on the evolution of the subordinated markets?

Charles Sanford, Babson (pictured below): That’s a tricky one. Because it is just as easy to see those instruments strongly benefitting from reduced uncertainty — see the price action on AT1s on better headlines on Monday and the solid appetite for those structures earlier this year — as it is to see a wave of issuance flooding the market. However, our view on the subordinated market remains driven by supply and regulatory developments rather than the situation in Greece. Most national regulators and banks are yet to determine their preferred option when it comes to MREL/TLAC compliance; senior unsecured eligibility is also very much an open question, and those are likely to be among the main drivers for the subordinated market in the next few quarters. We have indeed seen a reduction of issuance since April, but the market is not closed either despite concerning Greek headlines. It’s also worth noting that before the sharp rise of volatility of the past two months we saw a fair amount of second/third tier names announcing roadshows for potential Tier 2/AT1 transactions, and we think that we should see a more diversified range of issuers in this market.

Charles Sanford 0044

Scarin, Generali: Yes in the short term, not much in the long term. In recent weeks high beta assets such as subordinated bonds have been significantly impacted by the Greece saga, especially due to higher liquidity risk and inability to attract marginal buyers in the secondary market or in the primary one for second tier issuers. The disappearance of marginal buyers, however, is more a technical than a fundamental factor and therefore it should reverse when the situation stabilises. As such, in the longer term the primary risk factors impacting the outlook of sub bonds will be regulation, supply and issuers’ fundamentals, especially for deeply subordinated securities.

Goldfischer, CACIB: A last minute deal in Greece will not change investors’ view of the subordinated space. What it will change investors’ view on is a reduction of volatility and a confidence that there is a well-functioning secondary market. Investors want to be able to sell positions if they want without having to pay a significant bid-offer. Contrary to that, new issue premiums will increase as investors will need to price some cost of exiting positions in secondary market.

Julien de Saussure, EDRAM: Contrary to 2011, banks and insurance companies have limited and manageable exposures to Greece or Greek corporates. Based on the data available, a bad outcome would be manageable for most issuers. So a last minute deal would not dramatically change our long term view of the subordinated markets either.

Our long term view is mainly driven by regulatory changes and the creation of the European Banking Union. In this respect, the asset quality review, in particular of Greek exposures, is already demonstrating its merits.

A failure to strike a deal with Greece could, however, have an impact on the long term construction of the European Banking Union. But conversely, a weak deal with Greece, with perceived concessions from the Troika, could spread anti-Europe sentiment in other countries with elections/referendums in the coming years, namely Spain or the UK.

In the short term, however, a deal with Greece, even though most investors are aware it would not represent a lasting solution to the sustainability of Greek debt, would bring confidence in risky assets and the subordinated market would continue its expansion.

Craig Guttenplan, Rogge: Greece notwithstanding, there is a fairly clear path the subordinated markets should take over the intermediate term – though pending a few important developments, notably around final TLAC/MREL rules and proposed changes to bank creditor hierarchies in national insolvency laws. For most issuers, the benefits of issuing AT1 equal to 1.5% of risk-weighted assets is quite obvious, while it is becoming increasingly clear that Tier 2 materially above 2% is not the concern it once was when the initial TLAC proposal was published as banks without holding companies are likely to issue either German-style senior or else Tier III. The question of Greece and volatility in general speaks more to the timing of such issuance, but over a multi-year period we think issuance needs are now largely well-known and digestible – absent unforeseen changes to TLAC/MREL rules.

What are your views on the developments in US monetary policy and a potential rate hike before year-end? What consequences do you foresee?

Goldfischer, CACIB: The Fed rate hike that is priced in for later this year will not be a material event for the market on a standalone basis. What will be critical for the market is the pace of the subsequent hikes. In this environment, we believe that High Yield products will outperform Investment Grade products.

Scarin, Generali: The first potential rate hike before year-end should not come as a surprise, and market participants are anticipating that well. However, it is very important to distinguish between a single rate hike — that will come soon — and a significantly less accommodative monetary policy in the US, which is miles away from the very rational and prudent Federal Reserve’s behaviour and utility function. A strong and unexpected shift in US monetary policy would cause an immediate sell-off in risky assets first, with subsequent impact on consumer confidence and growth expectations, thus frustrating all the efforts made in the last six years to stabilise the economy and financial markets; we assign a close to zero probability to such an event.

The much more likely scenario of a smoother exit from the Fed stimulus would not derail US financial markets and growth prospects, even if a dollar appreciation should become the key risk factor for the emerging market assets first, where the higher level of US dollar-denominated debt reached in the last years is a source of concern, and higher default rates could suddenly reverse the flows dynamics and the relative cost of funding.

Brandenburg, Fidelity: Well, we have already seen a rise in US yields. Longer duration Lower Tier 2s underperformed relative to AT1s recently, so from that perspective I thought the AT1 market reacted very well to the back-up in rates. It underlines the fact that the market for USD denominated AT1 appears much deeper in terms of the groups of investors that are involved.

Hoarau, CACIB: The impending Fed interest rate hike — the first since 2008 — is a risk to global markets as the process could become disorderly. The move will likely happen after the summer break. The exact timing still depends largely on the economic outlook. Markets say they are prepared, but when the rate hike actually come to pass it could have very different consequences than in the past simply because the world is really in a different place. Liquidity today is just outrageously poor although vital to absorb the shocks implied by such a material change in monetary policy. Banks have to scale back their “market-making” capabilities to please regulators. When the market gets the shock of the effective start of a round of rate hikes, potentially violent price swings, which a disfunctional secondary market can’t smooth out, may lead to another round of price correction. So keep your seatbelt fastened: volatility in fixed income products is not over and changes in currency equilibrium may exacerbate the situation.

How do you cope with the return of volatility? What adjustments have you made to the way you approach investments, in primary as well as in secondary markets?

De Saussure, EDRAM: The main adjustments have been to increase cash balances and reduce exposure to long duration insurance bonds, which are more sensitive to curve steepening.

Our appetite for duration and peripheral exposure at the portfolio level has always been moderate and we have not changed our view in this regard.

As far as primary markets are concerned, we have continued to invest in bank primary deals with decent new issue premiums, considering that spread is a decent protection against rising yield. On the insurance segment, we tend to consider that syndicates have been slightly pushing deals while rates had already started to rise. We believe it is primarily a reflection that the decision to issue is based on spread levels for a bank, while insurance consider the all-in yields. As a result, having seen the impact of very low yields on their solvency position in Q1 2015, some insurers were quite keen to issue cheap regulatory capital ahead of coming calls and the 2016 start of Solvency II.

Guttenplan, Rogge (pictured below): Volatility clearly holds up the primary market but can make for interesting opportunities in the secondary when we believe that valuations have overshot fundamentals due to perceived contagion or other technical factors – though timing the entry point is obviously the tricky part. We are particularly wary of the current dearth of liquidity, especially during periods of volatility, so try to position for it when we anticipate volatility picking up.

Craig Guttenplan Rogge_Global_Portraits_14_05_15_0106

Scarin, Generali: Higher volatility in what are theoretically low risk assets is something investors should be prepared for, as highlighted also by Mr Draghi in one of his recent press calls. When you are not compensated at all for assuming a certain risk (duration), you should normally expect small triggers to have significant impacts. In general, the main sources of protection you have in such an environment come from the efficient management of your cash balance (sometimes with high opportunity cost) and, most importantly, diversification. As real money asset managers, mainly covering insurance-related portfolios, we have strategically increased our efforts towards investments with a strong fundamental research backing, especially in the primary market. In the secondary market, we kept on with the usual strategy of keeping high book-yield bonds, avoiding dismissing high quality assets in a way that we know would be quite inefficient.

Sanford, Babson: In addition to heightened rate volatility, idiosyncratic risk has definitely returned to the credit market. We have addressed this by diversifying our investments and allocating our risk budget across a wider range of securities. Given our reliance on fundamental credit analysis to generate investment ideas, we tend to focus more on the secondary market to source investments. While liquidity has been challenging in general, our strong relationships with the sell-side have allowed us to take advantage of specific opportunities our analysts have identified. That being said, there have been some great opportunities in the primary market as well.

What’s your strategy to cope with the rise of outright yield levels?

Sanford, Babson: We have run a series of scenarios that encapsulate our views on potential rate and spread movements across industry sectors and tenors to help us determine our duration and curve positioning.

Guttenplan, Rogge: In general, we tend to hedge our interest rate exposure when allowed and focus solely on the spread component.

Alloatti, Hermes: High yielding assets such as subordinated financial paper display less hard duration characteristics. On average, AT1, for instance, are closer to par, with 50 bonds wrapped around a mid price of 102 at the time of writing. Also most of them reset at the swap rate. The asset class is much closer to equity hence sizing of position and implied volatility are paramount.

Scarin, Generali: The direct effect of a rise in yield levels is clearly a mark-to-market one. However, higher yields also implies better reinvestment opportunities, especially for big insurance companies with legal liabilities to cover, and that is a very important point. For sure, what had begun as a pure rates repricing is now having some effects on spread levels across different credit products and on liquidity conditions in the secondary market. Investors will have to take a closer look to these dynamics and decide which logic is best to apply for their purposes. Since 2008, 10 year Bund yield has collapsed from 4.50% to basically zero. Prudent portfolio managers always adopt a medium term perspective in their positioning, and higher yields will prove to be beneficial to the market as a whole when short term volatility will have been absorbed.

We have full-scale QE in place and yet assets sell-off across the board. Is this contradictory? Would you say that the strategy of the ECB is delivering the expected effects?

Scarin, Generali: Theoretically that is contradictory, but in practice we have already seen in the past many episodes of market prices anticipating central banks’ announced actions, so that should not come as a big surprise. We believe it is definitely too premature to judge the ECB strategy. European financial markets were pricing a prolonged deflationary environment with no hope of solving the bank lending situation in the periphery market, especially for SMEs. Summing up this fundamental factor with the extensively discussed technicality of negative net supply in the European government bonds market, the resulting squeeze had probably come to an unsustainable level. Markets had to correct and so they did.

De Saussure, EDRAM: The ECB QE seems to have averted deflationary pressure for now, which was one of its goals. Anchoring inflation expectations is a good thing in that sense.

Guttenplan, Rogge: QE and sell-offs are not contradictory as markets can get ahead of themselves (as we saw with the recent rate correction) and/or legitimate crises can dwarf the positive impact (as with the ongoing Greek saga). ECB actions including both QE and the TLTROs are helping to modestly boost the real economy by lowering borrowing costs and making exports more attractive, but it will take significant time and more structural reforms to put the Eurozone on track for solid and sustainable growth.

Sanford, Babson: It does indeed feel like the ECB QE impact is now exhausted and that the big squeeze in credit will not happen, with IG credit spreads now largely back to their pre-QE levels. But the sell-off is not too surprising in itself if you consider that the past few months have been fairly eventful (Greece, Russia/Ukraine) and that we saw higher-than-expected issuance fuelled by corporates domiciled outside of Europe. Add to this a sharp rise in Bund yields (and volatility), which you could view as a consequence of higher oil prices and inflation expectations, and it seems only fair to see the recent repositioning. Still, compared to other asset classes, credit has not done too badly, partly thanks to a steady stream of inflows in the asset class — and the ECB is not done buying. So we would not be surprised to see some retracement in spreads in the next few months. What’s more worrying for us is the current state of liquidity…

Alloatti, Hermes: It looks like the ECB is intending to stay the course. The jury is still out, but the willingness to fight any risk of deflation is definitely there. And the market shouldn’t underestimate this factor.

What would you say are the main risks in the subordinated markets at the moment?

Sanford, Babson: There are several, but supply and liquidity are probably the first ones coming to our mind.

When it comes to supply, the final rules on TLAC and MREL play a big role, but are not expected until the month of November. The final decision around the eligibility of the outstanding senior unsecured debt will notably play a significant role in determining final issuance needs. A lot could in fact depend on how national regulators will react to those rules: Will more countries follow Germany and make OpCo senior unsecured debt TLAC-eligible? Will we see a new “Tier 3” type of debt emerge? Or, will most TLAC needs be met via Tier 2? Some banks have already indicated they will wait for the final rules before filling their MREL-TLAC buffers, but others may choose to strengthen capital buffers before the final figures are released. French banks have already indicated, for instance, their preference for Tier 2 debt in order to protect senior unsecured creditors, which could put pressure on this part of the capital structure. Supply risk appears particularly plausible if you think that investors tend to expect issuers to comply with new requirements as early as possible. Another risk for supply that we see is the increasing issuance from non-European issuers in the euro market, as seen earlier this year, if you expect continued US dollar strength.

We’re also painfully aware, as are many others, of the lack of liquidity in our markets and of the swings in prices this has triggered. Price volatility is proving particularly true for the subordinated markets, and shows that a strong domestic investor base matters.

Scarin, Generali: I would say the main risks for sub bonds at the moment are Greece and the worsening liquidity situation of risk assets causing wider credit spreads. We should not forget that subordinated bonds often trade in cash price and as such they should outperform senior unsecured bonds — that tend to trade in spread — in the first stages of a higher yield environment. However, Greece and liquidity are two risk factors with no clear parallels in financial market history, and that is preventing investors from taking excessive risk. If you sum up the two with the significant expected supply of bonds in the subordinated space, it is quite normal to see the current cautious stance going on.

Goldfischer, CACIB: The main risk is the saturation of the market. Regulation is pushing for a lot of expected supply across European banks, and if everyone wants to be “ahead of the curve” we can face a bit of what happened late last year when the primary has far too many deals in a short period of time.

Alloatti, Hermes: Apart from rates volatility, oil price vagaries, spill-over from bond repricing and macro developments (read Chinese slowdown), complacency and lack of differentiation between issuers are the main risks at the moment.

Brandenburg, Fidelity: I would say — and this applies to AT1 as well as other markets — it is around the question of secondary market volatility and the lack of capacity to trade the product.

The question with liquidity is whether this is purely a pricing issue, or whether there are fundamental problems around secondary market structure. A lot of it has to do with regulatory interventions at the banks, more than anything else.

De Saussure, EDRAM: Political risks are going to weigh at least until the end of the year and the elections in Spain.

Further interest rate shocks could also weigh on longer dated bonds.

And finally, as we move into 2016, MDA restrictions will kick in and could create some risks on specific AT1 issues.

Guttenplan, Rogge: The main risks in Europe are clearly geopolitical (Greece, Russia, oil) and economic (particularly in the Eurozone). Regulatory risk also plays a role for subordinated financials as the quantity and quality of bank capital is being scrutinised and harmonised both at the regional and global levels, with regulators still focused on making the industry safer and more transparent — which in the long term should be positive for the sector as a whole.

The lack of liquidity from dealers holding less inventory is also a major concern for subordinated financials, particularly for smaller-sized and lower-rated issues.

Hoarau, CACIB (pictured below): We are all focused on the Greece situation and headlines are driving sentiment. A weak deal will be closed at the last minute and thereafter the focus in European debt markets will switch to the issuance pipeline. Additional funding needs implied by MREL/TLAC compliance and subsequently heavy supply in subordinated debt may weigh on sentiment at some point. The primary market has been very, very slow in Q2. ABN and HSBC took the advantage of first mover advantage and got it right on timing for their recent Tier 2s. There are tonnes of subordinated deals that have been announced but not executed yet and the summer is looming. So September is going to be buoyant, with a risk of indigestion. July may see negative headlines increasing around the situation on Ukrainian debt, but the major event until year-end remains the timing and the approach taken by the Fed towards hike US rates. Elsewhere, there is a lot of uncertainty surrounding Spain’s general election in November. As we speak the risks to markets look contained. But populist movements in Europe are gaining importance and the way Tsipras battles the Troika at the moment tells us not to underestimate the significance of this event.

Vincent Hoarau image

What’s your view in terms of spread evolution and issuance volume in AT1 and Tier 2 during the second half of the year?

Hoarau, CACIB: Given the number and nature of the risk factors ahead of us, I can’t see any serious catalyst for a sustainable change in global spread direction before year-end. Discipline, anxiety, sensitivity to price and selectivity will predominate while premia will remain elevated in a rising interest rate environment. Supply prospects are high and volatility — as flagged by Draghi — is set to remain at an elevated level. Non-repeat issuers from core regions will continue to outperform, but globally I doubt we will be back to the levels seen at the end of the first quarter. Only evidence of strong economic recovery in Europe can be a game-changer.

Guttenplan, Rogge: The subordinated debt market will be interesting to watch in the second half as we await two key decisions in the fall that could materially impact issuance volume and potentially spreads — final TLAC/MREL rules and approval of the German senior bond subordination law. Material changes to which instruments are eligible for TLAC/MREL could have significant implications for such issuance volumes, while approval of the senior subordination law, first in Germany and then possibly in other countries in Europe, will also dictate whether any incremental debt issuance is required above the existing stock of senior and if so in what form.

We are also wary of the large backlog of issuers in the Tier 2 space as well as the narrow windows for issuance given the typical summer lull as well as blackout periods for much of October.

Alloatti, Hermes: As we get more clarity regarding TLAC and MREL between September and the G20 summit in November we expect the supply of Tier 2 bank paper to gain momentum. Also, barring any catastrophe, it is fairly possible to see in the remainder of the year the same quantum of AT1 supply we have experienced so far this year.

Scarin, Generali: That is extremely difficult to predict. The Tier 2 market is more mature and diversified in terms of issuers (different fundamentals), structures (coupon deferability, perpetual versus dated) and sectors (banks and insurance), and it ranks higher in the capital structure so investors are more confident in taking that kind of risk even in volatile markets. However, issuance levels are possibly less predictable than Tier 1 in light of TLAC regulation and Solvency II developments. Spread levels are currently widening in Tier 2 also because of the quite tight levels it had reached.

The AT1 market is instead very different in nature. It is not a mature one, and many investors are still prevented from participating in it due to regulatory constraints (not always clear due to equity conversion and write-down features) and tail risk of zero coupon perpetuity. Clearly, spread levels are more attractive here and there are some relative value opportunities to exploit, precisely because it is still a dislocated market. In terms of expected issuance, initial calculations of 100bn in the next three years have to be adjusted downward, considering the lower risk appetite, the higher yield levels and the regulatory constraints.

Sanford, Babson: This will depend partly on the situation in Greece and on the volatility going forward. We’re closely monitoring supply and liquidity in the subordinated space, but our base case remains for manageable issuance for the second half, supported by banks focusing on meeting their 2% Tier 2 and 1.5% buckets rather than building TLAC buffers ahead of final rules. As a consequence, we currently expect subordinated levels to grind tighter in the second half, but continue to expect a certain amount of volatility in the markets, which could mean a market only open to the largest issuers.

Robelin, BlueBay: We do expect a fair amount of issuance over the next few months, which could be a bit of a headwind for the overall spread direction, because deals will have to be priced reasonably cheaply. On the back of that, having a lot of dry powder to take advantage of the new issues but being quite neutrally positioned in financial sub debt right now makes perfect sense, and indeed our intention — as long as the Greek story continues to play out as we now expect — is to be patient and disciplined in the way we will use our dry powder and put cash to work.

You are invested across formats in subordinated debt. Where do you see most value in the market, considering bank AT1, Tier 2 and insurance sub?

Robelin, BlueBay: Well you have to keep in mind that it is a very different investor base for AT1 and Tier 2. I think that Tier 2 bonds are truly going to behave like bonds going forward. They have a fixed maturity date, they have must-pay coupons, so the only risk you face when you buy a Lower Tier 2 bond is the risk of default. These instruments are typically rated investment grade as well, so to us they are perfectly suitable investments for a kind of plain vanilla classic investment grade corporate bond fund.

If you look at AT1 securities, I think they are attractive, and I would argue they are attractively priced versus Tier 2s, but that being said, they are really hybrid capital and I would argue in particular that with the new regulation and the new type of instrument — with the optional coupon payments, with the ability to pay dividends on equity and not pay the coupons, with the ability for some structures to fully write down while the bank is still a going concern entity — you could argue that, for some structures at least, these instruments are actually subordinated even to equity. And so on our side, because our investment philosophy at BlueBay has always been to make sure that all funds do what it says on the tin and invest in a way that is consistent with the mandate we have been given by clients, we have refrained from these AT1 securities for our benchmarked investment grade funds. We have launched a dedicated CoCo fund, and we do buy AT1s for our next generation absolute return funds, because the mandate we have been given by clients is consistent with buying these more equity-like instruments, but we really think that the investor base for Lower Tier 2 instruments and AT1 securities is different. And therefore because the investor base is narrower for AT1, you indeed need valuations to be attractive to justify making that investment because there is more of a question mark above the size of the real, underlying dedicated investor base, versus the amount of supply that we expect over the next few years.

That being said, to be honest, I have been very impressed by the resilience and the liquidity demonstrated in the AT1 bond market during the last few weeks, as the concerns around Greece grew. And I think that this has gone a long way to making investors more comfortable about the asset class. Perversely, one could argue that this will increase the risk that more investors who are not dedicated AT1 investors will engage in this market — what we call the famous off-piste investors, if you will, the “tourist” investors — and therefore the next time we have a bit of volatility, maybe AT1 will be a bit more vulnerable because there will be more tourist money that will decide to get out.

Brandenburg, Fidelity: AT1 has been relatively cheap recently, so I think if deals come now people are going to look at them. However, we need to protect ourselves so we are demanding higher new issue premiums, and we expect that to continue.

De Saussure, EDRAM: We still like legacy bank and insurance Tier 1 with short calls as a carry play with close to zero interest rate sensitivity.

We see value in AT1 and continue to believe that a well-priced deal with decent spread can offer a decent protection in an environment with yields rising moderately.

Long dated subordinated insurance bonds are penalised by longer duration and their IG status. They have been used by IG funds as a risk-on play as well as a duration play. Therefore they have proven the most sensitive to the reversal in both spreads and interest rates. Now, moderately rising yields are fundamentally positive for insurance companies as they reduce the gap between reinvestment yields and guaranteed yields, which is heavily penalised in Solvency II. So while these long duration bonds need to see interest volatility come down to perform in the long run, we tend to see unwarranted spread widening in this segment.

Guttenplan, Rogge: Absent an exogenous shock, at the moment we like the value in strong peripheral bank Tier 2, recovering core bank Tier 2, and strong core bank AT1. We believe there is a burgeoning fundamental recovery in the periphery (more entrenched in Spain and Ireland while Italy’s is more nascent albeit becoming increasingly tangible) which will benefit bank credit profiles including building high quality capital. In the core, we see several clear recovery plays in the Tier 2 space and also think AT1 of certain strong banks offer attractive carry given what we perceive to be very remote trigger and coupon deferral risk in the near term in light of large capital cushions as well as lower risk business models and credit exposures.

Sanford, Babson: Despite the supply risk mentioned above, we continue to like the Tier 2 space as we feel that the new issuance to year-end will remain manageable in most European jurisdictions — most banks should wait for final rules and national regulators’ guidance to announce plans for TLAC issuance. The space should also benefit from a growing CET1 capital base and improving credit profiles, but still offers a good pick-up versus senior curves. At the end of the year the technical picture could, however, change significantly.

The AT1 space also appears attractive at the moment, and we feel that post-widening a number of AT1s issued by strong credits offer adequate compensation for the risk embedded in those structures. Taking into account the difference in structures, European AT1s also compare favorably to AT1s issued out of the EM space. However, despite the growing size of the market there still isn’t any natural investor base for this market in our view, and we prefer to be opportunistic in the AT1 space.

We are active in the sub insurance space but invest in it more opportunistically. We look at the senior/sub spread relationship of a given credit as well as how it is priced relative to BB securities. Currently, this sector seems tight relative to how it has been priced on both measures over the past one and three year timeframes. Securities with low back ends have had very poor excess returns recently as investors anticipate rising rates and price in extension risk.

Scarin, Generali: When we balance all risk factors, we tend to believe subordinated insurance bonds offer the best relative value. More standardised structures, better company fundamentals and a bondholder-friendly stance. Solvency II should also prevent companies from undertaking excessive asset risk, which has historically been the first driver of spread evolution in insurance bonds. The key mark-to-market risks here come from the higher duration and the significant supply of bonds the market has absorbed so far, with subsequent risk of indigestion.

Alloatti, Hermes: At the current juncture we find the sub insurance space to be one of the most attractive in terms of risk/rewards. The insurance industry broadly maintains that Solvency II will not be capital-raising while conceding this new regime could affect the timing of cashflows.

Robelin, BlueBay: If you look purely at valuations, the insurance sector has really underperformed lately, and arguably it looks very, very cheap versus bank sub debt. That said, it is important to recognise that there is a very clear improving trend in banks’ credit fundamentals on the back of the new regulatory developments that to us justify the positive trend in bank spreads and an expectation that bank spreads will tighten over time.

Against that, if you look at insurers, I would argue that the new regulation doesn’t particularly make them less risky going forward. The combination of new regulation and super low levels of rates actually brings existential issues for the insurance sector, we believe, and a greater risk of consolidation in insurance values in the future. We all remember the famous Equitable Life in the UK and the way guaranteeing high returns to your policyholders can become highly problematic as interest rates fall. And so I would argue — and this is something that is quite obvious to us — that the dramatic fall in interest rates, and the risk that they could stay low for a very prolonged period of time, is to some degree an existential threat to a number of insurers in a number of jurisdictions, and increases uncertainty.

So while you have a clear improvement in the underlying credit profile of banks, it is actually the opposite for insurers. And as much as a snapshot credit profile of a particular sector or a particular issue matters, markets tend to anticipate the direction of travel and price spreads accordingly. So I can’t really say we are surprised to have seen insurance spreads underperform bank spreads because of these opposite dynamics in credit fundamentals.

That being said, it feels like the recent move has probably been somewhat excessive and certainly for the strongest insurers, or those with a good specific bottom-up story. So, for example, it is our expectation that Groupama sub debt will be upgraded to investment grade over the next few weeks. We feel that valuations have probably cheapened up too far and we are happy to re-engage in sub-insurance as well.

Would you say that the AT1 market is closed for non-core issuers?

Alloatti, Hermes: With regards to the peripheral issuers, we think the market is not always closed to them. But the clearing price might be somewhat higher than the banks’ expectations.

Scarin, Generali: I would not say so, but one has to adjust this judgment in light of the current non-standard investors’ base. If the AT1 market were a developed one, with a diversified pool of investors within it, in the current volatile market it would likely be closed for non-core issuers. However, that is really not the case. We had new issues recently from peripheral issuers or second tier banks in general, with structures and sizes probably designed to satisfy the increasing demand from Asian private banks or dedicated mandates. Also, the currency played a crucial role in that sense. But such a situation could possibly change.

De Saussure, EDRAM: No, not necessarily. A well flagged deal like Bank of Ireland AT1 was priced while volatility had already started to increase, because they have a widespread audience of funds closely following the name and already invested in the either the 2016 CoCo or the 10.24% Baggot securities.

Most traditional AT1 issuers would probably want to wait until volatility comes down before they issue. Some issuers have refinancing deadlines or specific milestones that could explain issuing now, but we believe there is an investor base for these deals offering potentially an increased new issue premium.

Guttenplan, Rogge: Recent issuance by the Irish banks, in particular the heavily oversubscribed Bank of Ireland deal, which is one of the lowest rated and widest trading AT1s, shows that there is demand for the right name and structure. Second tier banks still need to be opportunistic and find the right investor base, but the range of issuers that have come to market over the past two years shows that there can be demand even for off-the-run names.

Sanford, Babson: We would probably say there is a price at which investors will look at peripheral issuers in the AT1 market and strong business profiles in non-core countries that will meet investor demand, including in difficult market conditions. Earlier this month, and in a context of widening spreads, we saw Bank of Ireland successfully sell Eu750m of an attractively priced low-trigger AT1. The bond was more than seven times oversubscribed and has proven resilient in the current volatility. We could easily imagine other top tier peripheral names issuing in the AT1 space with a similar outcome if they offer a sufficient premium for volatility.

The AT1 market is maturing and investors are getting a better grasp of the risks of this instrument. Strong capital buffers, a supportive domestic investor base, recurrent earnings capacity and limited supply needs are in our view major considerations when investing in those instruments, and with the right premium for volatility the market should be able to absorb AT1 issuance with such features coming to the market, whether from core or non-core countries.

Brandenburg, Fidelity: No, I think the market will reopen for a variety of issuers, so that includes top tier as well as good second tier names. You saw Abbey National printing in relatively difficult circumstances, which is a good example of what is possible, and also Irish Life & Permanent, which is a tiny Irish bank.

Hoarau, CACIB: AT1 instruments have suffered across the board, but I was positively surprised to see the resilience demonstrated by national champions out of southern Europe. When it comes to second-tier borrowers in non-core jurisdictions, supply should be relatively limited until the end of the year and candidates ready to brave the market should find a fair audience providing that volatility comes down, market sentiment improves, and they are ready to pay levels higher than fair value to capture decent demand. Investors have not gone on strike. The cash is also available for weaker signatures but investors want to get this extra yield to compensate for the greater mark to market risk and more importantly the quasi-non-existent liquidity available for higher beta names in the secondary market. Almost everyone here emphasised the liquidity challenges and in difficult markets you may not find any exit strategy when you invest in AT1 bonds issued by smaller borrowers unless you get out at a prohibitive price. So we may see more and more club deals from non-core issuers looking for sub-benchmark size and bought by rare “buy and hold” AT1 investors. In that format you simply avoid the involvement of those opportunistic tourist investors and make the valuation of the bond less vulnerable to phases of volatility. In terms of how they approach primary, non-core issuers should not be shy but be ready to go on the road in difficult markets even if they are forced to wait after they have met investors. There is little harm in doing roadshows, then at least you can act quickly when the issuance window is there and markets stabilise.

There has been a fair bit of talk about Tier 3. How do you see those discussions evolving?

Guttenplan, Rogge: We view the Tier 3 approach as simply a Plan B in case the German subordination law fails to be approved first in Germany then across other countries in Europe. Countries and issuers want to keep all options open for meeting TLAC/MREL requirements in the most cost efficient manner and we believe that Tier 3 could be a more expensive form of debt than subordinated senior i.e. more in line with senior HoldCo than senior OpCo given where it ranks in the bail-in waterfall and the likely relative size in the capital stack.

Scarin, Generali: We could see some new “explorative” issues here, but we tend to believe the market for subordinated bonds has already developed significantly in recent years in its Tier 2 and Tier 1 buckets. Also, one should not forget the strong increase in hybrids issued by non-financial corporates, adding a further investment possibility in a broader diversified portfolio. But all these opportunities in the subordinated space could lose some appeal in a normalised interest rates environment, because many “tourist” investors who are currently buyers could go back to traditional senior unsecured investments, being able to satisfy their target returns with lower risk assets.

Alloatti, Hermes: Tier 3 in some instances represents a contractual subordination and as such does not seem fully in sync with the statutory subordination the FSB is advocating.

De Saussure, EDRAM: Since the G20 in Brisbane and the proposed TLAC structure, structuring teams have worked hard on Tier 3.

The option to issue instruments pari passu with Tier 2, but not treated as regulatory capital doesn’t seem to have traction anymore, as investors are not ready to price that differently than a Tier 2.

Introducing new layer of instruments ranking between Tier 2 and senior unsecured is now at the center of the debate. Most banks have already amended their EMTN prospectus so that, when old Tier 2 are extinct, they can insert that new layer.

By the way, we believe there is an over-interpretation in the market of the recent changes in the Spanish insolvency law. As far as we understand it, contractually introducing a Tier 3 in Spain would have been superseded by the non-existence of Tier 3 in liquidation. As a result, Spanish banks are now on an equal footing with other jurisdictions and can introduce Tier 3, if the existing stack of Tier 2 does not prohibit them from doing so. Now, there very little amount of Tier 2 in Spain and therefore some Spanish banks could start issuing.

We have quite some sympathy with the so-called German option in BRRD — senior unsecured can be bailed-in and we had a painful consensus on that. So let’s work so that it can be TLAC-eligible as well. Obviously, making deposits “preferred” in liquidation may be a more desirable option than making senior unsecured “junior”, so as to avoid mandate restrictions on subordinated instruments. It could have negative consequences on senior ratings, but we would expect most banks to continue to issue capital instruments in due time and credit-enhance their senior unsecured bondholders and protect their rating. But at least they would be more quickly TLAC-eligible with a more limited and more disciplined Tier 2 issuance pipeline in the near term. The European economy is still very intermediated and senior unsecured funding is a major funding tool. Therefore its rating will continue to matter and banks would still be incentivised to maintain superior ratings. In more disintermediated economies like the US, transforming HoldCo senior unsecured into a bail-in-able instrument, i.e. a last tranche of the capital stack, is less of an issue. The recent news that structured funding could be TLAC-eligible under certain conditions, contrary to the initial TLAC term-sheet, may pave the way for some of the French banks to support a “German” solution. The exclusion of vanilla structured notes, heavily used by French banks, was indeed one of their key concerns after the initial TLAC proposal.