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The technical factors that contributed to spreads rallying through 2024 to rich valuations are expected to persist in the coming year, but a Crédit Agricole CIB survey of 118 investors found a bearish bias for 2025, as the outlook for monetary policy become less obvious and potentially damaging.

Open from the beginning of November to the beginning of December, the survey attracted some 118 responses from investors. Sixty-nine were prominent asset managers, with the remainder spread across ALM desks, insurers, hedge funds, central banks and official institutions, corporates, pension funds, private banks and others.

On the overarching question whether they feel bullish or bearish about credit spreads in 2025, 60% of the investors are negative on the outlook, compared to 40% positive. The bearishness comes at the end of a great year for credit that has nevertheless left valuations at tight levels.

“There was a strong bullish consensus at the start of the year as to what credit would look like in 2024,” says André Bonnal, FIG syndicate at Crédit Agricole CIB, “but although there is a bias for 2025, it is the other way around and by no means a strong consensus.

“The bearishness probably comes from where spreads are in absolute terms and on a relative basis, not necessarily the overall tone of the market,” he adds. “A lot of people are actually going into the New Year knowing that technicals are very strong, but with spreads so compressed, they are a little bearish because it’s not clear to what extent the market can go tighter.”

Indeed, when asked which of four statements most appropriately describes the evolution of FI credit spreads in the first quarter (with multiple answers possible), 54% chose the option that technical supports are strong and current spreads could maintain the status quo for a while or tighten. And on a three month view, investors were also more likely to deem the spreads of AT1, Tier 2 and senior preferred attractive than unattractive.

Which of the following statements seems the most appropriate to describe the potential evolution of credit spreads in FIs throughout Q1 2025? (multiple answers possible)

Source: Crédit Agricole CIB

On top of tight spreads, Bonnal highlights that several risk factors coming into focus for 2025 may be contributing to the bearish bias.

Score each spread driver in terms of importance from 1 (very important) to 5 (least important) in the near future

Source: Crédit Agricole CIB

Uppermost among these in respondents’ minds are the European economic situation and US fiscal policy, with the latter proving marginally more of a concern. Interest rate volatility ranked third, and Vincent Hoarau, head of FIG syndicate at Crédit Agricole CIB, notes that the US economic situation overall will be key to developments in 2025, with reflation risk also a cloud on the horizon.

“In December 2023, the market was expecting six rate cuts in the US,” he says, “but when we look at monetary policy there in 2025, there is a lack of certainty. The market is pricing in two to three rate cuts by June, but no more than that, and the rate-cutting cycle scenario can be seriously questioned. We may end up with a simple recalibration of the monetary policy rather than a proper cycle of rate cuts.

“The big surprise of 2024 was that the US economy has not landed and we still don’t know if or when it will. And on top of that Trump is more inflation-friendly than anything else — don’t forget that last time around the market experienced weakness every time he tweeted something about tariffs.”

Although a potential reverse in the direction of rates could spell further trouble for commercial real estate, the sector has fallen sharply down investors’ agenda, ranking lowest among the possible spread drivers they were asked to score.

Divergent US, European paths

Visibility on the outlook for Europe is greater than for the US, but its contrasting economic situation is set to be a key factor in 2025 developments.

“The question now is to what extent the very big macroeconomic spread between Europe and the US will cause some market volatility with regards to the shapes of the rate curves, with potentially a sharp steepening of the US Treasury complex and euro swaps following in sympathy — hurting long-dated assets most,” says Hoarau. “For the time being, everyone wants to own US-denominated assets and US dollar inflows have been exceptional in November.

“There is stronger uncertainty with regards to the situation in Europe but we are not concerned for euro credit. The rate direction in Europe is very clear — we are likely going to have one rate cut at each and every central bank meeting in Europe for at least the first half of 2025.”

Some 64% of survey respondents expect 10 year euro mid-swaps to remain relatively stable in a 2%-2.5% range, with 28% expecting a lower rate — possibly suggesting a median above but close to 2%. Just 8% expect a rate above 2.5%.

When it comes to their tenor of choice for January, the belly of the curve appears the most popular among investors, with 56% choosing up to five years and 50% five to seven years (multiple answers were possible). Short dated FRNs were selected by 12%, seven to 10 years by 24%, and longer than 10 years by 9%.

“This makes sense,” says Bonnal, “especially if you consider that rates may be going up in the US, so you don’t necessarily want to load on too long duration, while in euros up to five, seven year part of the curve is pretty consistently favoured from one year to the next.”

For credit, what will be your tenor of choice in January 2025? (multiple answers possible)

Source: Crédit Agricole CIB

The evolving monetary policy situation in 2025 will stand in marked contrast to 2024, which saw investors benefiting from functioning forward guidance from central banks.

Hoarau suggests this helps explain a relatively muted and ambivalent impact from recent announcements on respondents’ behaviour towards bank debt.

“The recent meetings have been pretty much a non-event,” he says. “Since the start of the rate cuts on both sides of the Atlantic, the trajectory has been relatively straightforward.”

How is your investment behaviour being influenced by the recent central bank (Fed/ECB) meetings and rate announcements?

Source: Crédit Agricole CIB

Despite not ranking as the biggest concern for most investors, French and German politics was the topic fewest investors deemed to be of low importance. The Barnier administration in France fell in the midst of the survey — although later respondents scored core European politics lower in importance than those who completed it early, with Bonnal noting this tallied with the OAT-Bund spread tightening 6bp on the day of the government’s collapse, partly because so much bad news had been priced into French bonds.

“It’s a kind of, buy the rumour, sell the fact,” adds Hoarau. “I wouldn’t read too much into positive developments in the direction of OATs — going into year-end, more and more people have taken a neutral stance on this theme because nothing is certain. Meanwhile, the concept of shutdown doesn’t exist in France — the 2024 budget will be repeated and run until there is some kind of resolution.

“The only question is, when do investors start to get upset about the situation? We will see. In any case, given the recent underperformance of French risks, the jurisdiction looks fairly attractive, and even a downgrade of the sovereign seems to be priced in.”

Geopolitical tensions meanwhile appear to be a secondary concern for investors, even if they were reminded of the Middle East crisis, among others, with the overthrow of the Syrian government beginning while the survey was being conducted.

“It’s not the clear preoccupation of investors,” says Bonnal, “which gives you the impression that they have learned to live with geopolitical risk after it proved not to be an issue for the market in the past year or indeed past years in spite of everything we’ve seen. Keep calm and carry on, and all that.”

Balanced against the risks contributing to investors’ bearish bias are the factors that have helped bank debt reach the valuations at which they stand today and which by and large will persist into the new year.

“Technical supports are potentially less strong than they were in December 2023, but they are going to mitigate quite significantly how much we could potentially widen,” says Bonnal. “The liquidity situation that has driven the market is still in play.”

Intertwined with this liquidity factor is the carry available, which Hoarau notes will again prove supportive.

“We may have lost some ground in the euro market, but we gained in US dollars,” he says, “but either way, the carry is still there to be enjoyed and protect investors from the return of volatility. As long as you can get 3%-plus on an IG paper in Europe, the market will continue to be fairly supportive — particularly when you look at the equity market, where things look very toppish, particularly in Europe given it’s heading towards zero growth if not recession.

“As long as rates remain not too far from where they are today, investors are not going to demand much greater compensation on a spread basis. And this is going to be supportive for the liquidity situation, where there is still a lot of cash to be deployed from money market funds into credit funds.”

AT1, SP preferred

AT1 is the part of the capital structure most commonly viewed as the most attractive by investors on a three month view, with 17% giving it the highest possible score. Combining the highest two possible scores, among unsecured and subordinated products senior preferred achieved the highest score, of 39%, just 1% ahead of AT1 and Tier 2. Some 20% of respondents said they expect greater differentiation among names in AT1 and Tier 2 instruments.

Considering the next three months, score each of the FI sub-sectors from 1 to 5, where 1 = very attractive spreads and 5 = not attractive

Source: Crédit Agricole CIB

More investors considered senior non-preferred as unattractive than attractive when looking at the coming quarter, while in the question allowing them to choose statements reflecting their view, 31% expressed an expectation that spreads in outstanding SNP/HoldCo will underperform on the back of primary market supply and a return of volatility.

Covered bonds emerged as the bank product attracting the fewest investors. Reading between the lines, a lack of focus on the asset class among respondents may have contributed to this outcome, although the lack of enthusiasm chimes with the unclear outlook for the instrument, according to Bonnal.

“On covered bonds, there is no consensus whatsoever,” he says. “There are those who expect covered bond spreads to underperform, but others who are not expecting much supply — as issuers might turn to senior preferred instead — and if supply undershoots, that will be positive for spreads down the road.”

Which of the following statements seems the most appropriate to describe the potential evolution of covered bonds throughout H1 2025? (multiple answers possible)

Source: Crédit Agricole CIB

Hoarau flags how the widening of Bund-swap spreads has contributed to covered bonds pushing wider, resulting in a narrowing versus senior preferred — a factor in the potential shift of issuance from the former into the latter.

“The covered bond arena is in repricing mode,” he says. “It has started, but I’m not sure it has ended, particularly for high quality names. The EU will fund more, up to €90bn in H1. This is likely to continue to be negative for SSA valuations overall and consequently add pressure on covered bonds spreads, particularly at the long end.

“This is also adding complexity in the assessment of Bund-swap spread direction and fair value.”

Bund-swap spreads came mid-table in investors’ ranking of spread drivers for the coming year. Some 53% of respondents expect the 10 year Bund-swap spread to be negative at the end of 2025, versus 47% expecting a positive spread.

Head south via France

Southern Europe, and Iberia in particular, is the most attractive area for investors when it comes to senior and subordinated bank debt in 2025. More than half, 52%, of respondents gave Spain and Portugal the most favourable scores, with Italy also ranking highly.

“If you look at the economic situation in Europe,” says Bonnal, “Spain, Italy and Portugal are now the growth drivers, whereas core and semi-core are lagging. This also tells you that investors don’t have any problem with southern Europe converging even closer to semi-core and core.

“This is also somewhat reflected in covered bonds, for instance — although supply from Spain, at least, could underwhelm investors again in 2025.”

Credit & Sub Debt: considering the next three months, score the following regions from 1 to 5, where 1 = very attractive and 5 = not attractive

Source: Crédit Agricole CIB

However, Greece divided opinion after a particularly strong performance, with 36% of respondents ranking it as attractive and the same number deeming it less attractive, and a relatively low number sitting on the fence.

“Out of southern Europe, it’s one of the areas that people think has maybe come so far that it’s too tight now,” says Bonnal. “But there’s a bit of a mixed consensus, since you only have to look at Eurobank getting a book of some €3.5bn for their third senior trade this year — that tells you there’s enough people who still think there’s performance to be had.”

The US was meanwhile deemed attractive by 45% of respondents, proving much more interesting than other non-European jurisdictions — Japan received the second least votes for being attractive, only beating Canada.

“Australia and New Zealand were also seen as trading on the expensive side versus some other countries,” says Bonnal. “It seems that if we’re not talking Eurozone, the US is the country of choice versus APAC and Canada.”

Canada witnessed the sharpest contrast in its unsecured and secured profiles, ranking third in attractiveness among covered bond regions.

“Canadian covered spreads are still seen as offering value,” says Bonnal. “And if you think of where Canadian senior trades versus covered, they are very close, and we’re talking about a technically bail-in-able product that banks use for their TLAC ratios — although pari passu with deposits — rather than senior preferred.

“The lack of supply may also be a factor in making investors think it is still attractive.”

Covered Bonds: considering the next three months, score the following regions from 1 to 5, where 1 = very attractive and 5 = not attractive

Source: Crédit Agricole CIB

Opinions on Canada were nevertheless relatively divided — as they also were for France. The country ranked second in attractiveness in unsecured debt, and in covered bonds came top, with 40% of investors giving it favourable scores.

“Current levels are seen as a good entry point,” says Bonnal. “Among national champions, we have seen some French senior non-preferred trade wider than its Italian counterparts in the past weeks, for example.

“Investors took their chips off the table earlier, in July-September, but now, while they might not think everything’s fine, people are OK with the status quo and levels are deemed attractive.”

You can download a pdf of this article, alongside a market focus, by clicking here.

Crédit Agricole CIB gathered major Nordic borrowers and French real money accounts in Paris on 14 February for its Nordic Bank Day, and Decque set the scene by noting that the overall European banking sector had entered the year facing three key areas of uncertainty: the extent of any recession; geopolitical tensions; and the development and impact of monetary policy.

Amid this new paradigm — also including the withdrawal of European Central Bank support — the way to play the banking sector in 2023 is via a stock-picking strategy, said Lereste.

“Combining the macro picture and higher rates with business model specificities,” she added, “we’ll see that the safe haven is the Nordics.”

Key factors cited by Crédit Agricole CIB’s analysts are very high MDA buffers combined with strong earnings generation — as highlighted by their banking radar (see below) where Nordic players are clearly among the best positioned of European banks.

Crédit Agricole CIB Banking Radar Issuers

Source: Bloomberg, Crédit Agricole CIB

Under a stressed MDA buffer scenario run by the analysts — including flat revenues, costs up 5%, LLPs back to Covid stress levels, and RWAs up 6% — MDA levels are still “very comfortable” for Nordic banks, according to Decque: ranging from 1.24% for DNB to 2.27% for Danske, for example, and 3.52% and 4.05% for Svenska Handelsbanken and Nordea, respectively.

“High rates means higher revenues that can partially absorb higher LLPs going forward,” he added. “The absolute level of NPLs has been extremely low, so even a doubling of NPLs remains largely manageable by banks. And there are still unused Covid provisions available, the so-called management buffer.

“Nordea has close to €600m available, for example, and Swedbank SEK2.2bn in overlays.”

At the same time, the exit from negative rates is good news for banks, and particularly Nordic banks who have all enjoyed increases in net interest income (NII) of more than 30%.

“We have, intuitively, the notion that positive rates support the whole financial sector,” he said, “but the impact will be quite different from one bank to the other depending on the profile of their loan book — the more long term fixed rate you have, the longer it takes to reprice your lending book, while the more short term fixed or variable rate you have, the quicker it goes.”

Interest rate risk in the banking book (IRRBB) and related supervisory tests bear out the view that Nordic banks perform favourably in this regard. For example, in the quarterly ECB “parallel up” test whereby rates rise 200bp along the curve, Nordic banks experience a positive NII impact and relatively mild changes in economic value of equity (EVE).

“The ones in the best position are clearly the Nordic banks,” said Decque.

The strong fundamentals of the Nordic banking sector are meanwhile well known, he noted.

“Very strong asset quality, better profitability than the European average, very strong efficiency, extremely low cost-to-income ratios — in the area of the low 40s, and clearly a good cost of risk. The same for the capital base compared to the European average.”

Where they are not scoring so well, added Decque, is in terms of liquidity and leverage.

“This is largely due to the historical habit of Nordic households investing much more in mutual funds and pension funds than depositing funds long term with banks. As a result, Nordic banks remain highly reliant on market funding, notably covered bonds and short term funding — that’s the only, let’s say, small weakness compared to the rest of Europe.”

Regarding capital, Decque  (pictured below) highlighted how Swedish banks face elevated requirements from their local regulator, citing the 2% level of the countercyclical buffer and aggregate 4% for the systemic risk buffer and other systemically important institution (O-SII) buffer. As a result, SEB, Svenska Handelsbanken and Swedbank face capital requirements above 14%, compared to some 9%-11% for the rest of Europe.

“So there is a massive difference in terms of requirement,” he said, “and they have to run with a very high level of capital.”

According to Lereste, in today’s environment, high credit ratings offer an increasing competitive advantage, and in this regard, the Nordics come out favourably — not just in terms of senior ratings, but also with their Additional Tier 1 (AT1) being largely investment grade, a status few other European banks enjoy.

Danske Bank, rated lower than its regional peers at A+/A3/A, is meanwhile seen as a potential recovery story. After clarification on the anti-money laundering front last year, a return to business as usual could see potential upgrades in the medium term, according to Lereste, offering the potential for outperformance — particularly given that the Nordics’ safe haven status is generally already priced in elsewhere.

While FIG supply pressures may this year prove less intense than initially feared, and supply year-to-date has met with strong investor demand, the high ratings should also stand Nordic issuers in good stead in a busy and competitive bond market. Nordic banks are expected to be active in fulfilling their MREL needs ahead of 2024, while Norwegian issuers specifically could opportunistically enter the market for Tier 2 and AT1 for P2R optimisation.

Real estate a pocket of vulnerability

With the exception of Norway, the Nordics are facing a mild recession somewhat worse than in the rest of Europe, highlighted Decque.

“The main reason is the fall in private consumption clearly linked to the fall in house prices, which has a wealth effect on households,” he said. “They are much more impacted by higher interest rates due to the variable rate mortgages they have to pay.”

This is borne out by the correlation between house prices and the evolution of domestic consumption, he noted, flagging a Riksbank study that showed Swedish households to be twice as sensitive to interest rate rises as they were 15 years ago, with debt-to-income levels having increased.

A key theme to explore in the challenging economic environment and in particular higher interest rates is the real estate market, according to Lereste, especially given that residential mortgages and commercial real estate lending represent more than 60% of some Nordic banks’ loan books.

“That’s why it’s one of the main concerns from investors,” she said, “that has also been highlighted by central banks as a potential pocket of vulnerability.”

After sharp increases, house prices have been falling since last summer, especially in Sweden, and are expected to fall further. Meanwhile, household debt, primarily in the form of mortgages, is high in the Nordics compared to the European average, at more than 150%, while mortgages — with the exception of Denmark — are generally floating rate.

However, Lereste (pictured below) noted that Q4 results have shown Nordic banks’ asset quality to be remaining “solid”, with Stage 3 loans remaining very low and among the best in Europe, while impairments have not increased.

“So, for the time being, what we are seeing is that they benefit from a double-digit increase in NII,” she said, “and at the same time, at least for the residential mortgages, asset quality is very sound. As for unemployment, it’s very low, while there is a robust social safety net and incomes are relatively high, so we are quite comfortable regarding exposure on residential mortgages in the Nordics.

“Don’t forget that they learned from their housing crises of the 90s,” added Lereste. “And, compared to the last crisis, the Nordics have more conservative policies, and in terms of loan-to-values, for example, we are talking about 50%-60% maximum on average.”

Concerns about commercial real estate are particularly high among investors and something to monitor in 2023, according to Lereste, with exposure to CRE greater than 10% of total lending, and more than 40% of corporate lending for Swedish and Norwegian banks.

“What is important for commercial real estate is cashflow,” she said, “and this can be impacted by the combination of high rates and economic slowdown, through rental income and also bearing in mind higher vacancies, while the sector potentially faces tighter credit conditions.”

Again, asset quality thus far has remained strong in spite of the tougher conditions, noted Lereste, while banks have adopted a conservative approach by increasing overlays for 2023.

“Considering all the metrics, Nordic banks should be able to handle this issue, although CRE vulnerabilities could pose headline risk for Swedish banks’ spreads,” she concluded.

You can download a pdf of this article, alongside a market focus, by clicking here.

You can download a pdf of this article, also including insights shared by regulators, issuers and investors, here.

Until now, sustainable bonds have for investors represented a proxy to integrate ESG into their investment strategies, and for issuers, a way to show that they are taking action against climate change, according to Léa Le Leonnec Serra, green bond-ESG fixed income analyst, Crédit Agricole CIB.

Despite challenging funding conditions, financials and non-financial corporates had contributed around 60% of year-to-date sustainable bond issuance, she noted, with financials alone accounting for one-quarter of the overall sustainable supply. Senior preferred and senior non-preferred have been the most popular issuance format for financials and Crédit Agricole CIB expects sustainable supply in the two formats to meet last year’s issuance level thanks to a catching-up of sustainable issuance at the end of the summer.

Although the past two years have witnessed a diversification of sustainable fixed income products from the traditional green bond into the newer sustainability-linked bond (SLB) format, this has been stronger on the corporate side, noted Le Leonnec Serra (pictured below). Financials have continued to focus on use-of-proceeds bonds, with the European Banking Authority still discouraging the use of SLBs by banks for MREL/TLAC-eligible instruments.

Greenium has meanwhile become increasingly visible, with Crédit Agricole CIB analysts putting it at some 6bp-8bp based on data across 15 European banks’ senior preferred and non-preferred bonds. A lack of relevant comparable bonds means that an analysis of subordinated debt is still limited.

“That said, we see that the bottom of banks’ capital structures seems to offer more spread room for the greenium,” added Le Leonnec Serra.

Within covered bonds, the greenium has improved recently amid high issuance that resulted in spread-widening, with green bonds attracting buyers whose appetite for classic covered bonds was already filled.

Buyside adapts to challenges

Within a context of increased ESG integration, in particular with regard to climate and transition objectives, the buyside is facing new constraints and opportunities, Valentina Sanna, green bond-ESG fixed income analyst, Crédit Agricole CIB, told delegates at the event.

“Firstly, investors are exposed to increased scrutiny on the climate impact of their activity, and also the impact of climate change on their activities,” she said. “On the one side, climate change and the energy transition impacts the profitability of companies they invest in, through in particular the negative potential impacts of physical climate risk, but also transition risk, meaning that investors need to integrate this new risks and opportunities into their return expectations.

“On the other side, they are also exposed to increased scrutiny of the climate impact of their investments, particularly some sectors like coal, oil and gas. This means they have to complement their financial objectives with environmental objectives.”

Secondly, investors are increasingly participating in net zero initiatives to show their willingness to take action against climate change, noted Sanna, such as the Net Zero Asset Managers initiative, the Paris Alignment Investment Initiative, the UN-convened Net-Zero Asset Owner Alliance, and the Net-Zero Insurance Alliance. This involves setting interim and long term targets, and periodically reporting on progress.

“And thirdly, increasingly investors need to adapt to new regulation that is bringing new ESG disclosure.”

Sanna cited three such regulatory developments facing investors: Article 8 of the Taxonomy Regulation, requiring disclosure of the Taxonomy-aligned percentage of their activities; the Sustainable Finance Disclosure Regulation (SFDR), requiring disclosure of how ESG risks are integrated into investment decisions as well as classification of funds according to ESG characteristics; and MiFID II, requiring that investors check clients’ ESG preferences and propose them appropriately adapted products.

“Faced with these new constraints and opportunities, the question for investors is how to integrate them into their operation,” said Sanna (pictured below). “Indeed, integrating climate risks and opportunities as well as aligning to net zero objectives and initiatives, and adapting to new reporting requirements, requires them to adapt their strategies as well as to adopt new data and metrics.”

New strategies could include engage with companies to drive change, she added, as well as capital allocation strategies such as tilting between and within sectors, divestments, and investment in climate solutions — with green bonds being a concrete example of the latter. To this end, investors can employ metrics such as absolute CO2 emissions and emissions intensity, and reductions in these, while also aligning with sector-specific pathways.

However, these approaches face challenges, not least in finding sufficient data, noted Sanna.

“While it is true that the Taxonomy adds a burden to the reporting of companies,” she said, “it will also be helpful, since it will increase the availability of data on the share of green activities at the issuer level, while also giving standard definitions of climate solutions and also standard CO2 product intensity for some sectors.”

Regulations spur change

As well as rising up the agenda of investors and regulators, climate and environmental risks are becoming top priorities for banks, who are increasingly putting such matters at the centre of their business models.

“Climate change and the transition to net zero poses risks to households and firms, and therefore to the financial sectors,” said Gwenaëlle Lereste, senior credit analyst, bank analyst, Crédit Agricole CIB. “Banks finance around two-thirds of the economy and as a consequence they are playing a key role in accelerating the move to a more sustainable economy.

“Reorienting private capital to more sustainable investments requires a comprehensive shift in how financials work,” she added. “This transformation will trigger business opportunities for banks, but at the same time will also lead to potential financial and reputational risk.”

This has been reflected in regulatory developments — Lereste cited revisions to CRR2 and CRD5 to include climate factors, as well as Pillar 3 disclosures and Pillar 2 requirements, with the integration into the SREP of the outcome of the first ECB stress tests — raising questions about potential climate capital rules.

“We view the ECB climate stress test as a credit positive start for the banks,” she said, “because it helps banks embed more climate factors into their strategies.”

An acceleration in banks’ ESG strategies has been reflected in the incorporation of climate factors in strategic plans, including long term commitments to reduce exposures towards fossil fuels, while supporting their counterparties to lower carbon emissions. European banks have also joined the Net-Zero Banking Alliance, thereby committing to aligning their goals with the Paris Agreement, as well as the Science Based Targets initiative (SBTi), with La Banque Postale in October 2001 being the first European bank to have its decarbonisation pathway recognised by the SBTi.

“ESG is gaining momentum from liabilities to assets,” said Lereste (pictured below). “However, even though the ECB has recognised the progress being made by banks, they are lagging in several areas and do not yet sufficiently embed climate risk in their business models.”

She highlighted discrepancies among European banks and a lack of clarity over commitments, targets and metrics.

“ESG risk will increasingly be a credit differentiator,” said Lereste, “but available and harmonised data remain a big obstacle.”

The data issue should also make it challenging for banks to report on their Green Asset Ratios (GARs), noted Sanna. Banks will have to start disclosing the key KPI in 2024.

“Some of the challenges include the availability of company data, quality and comparability,” said Sanna, “but also the need for new expertise, to assess the alignment with the technical criteria of the Taxonomy and do-no-significant-harm.”

In a pilot exercise last year, the EBA calculated a first estimate of just 7.9% for the EU-aggregated GAR.

“While the disclosures present some challenges,” said Sanna, “we think that more transparency could also be seen as an incentive for banks to green their balance sheets, which ultimately need to be decarbonised.”

You can download a pdf of this article, also including insights shared by regulators, issuers and investors, here.

What have been the key trends of 2021 in the financial institutions space?

The primary market for financial institutions has been marked by three major trends this year.

Firstly, despite good progress in banks’ issuance plans, volumes for the first half of 2021 are lower than in previous years, driven in particular by the reduced primary market activity in covered bonds. A combination of central bank policy and deposit inflows has provided banks with ample liquidity, and as a consequence they have less pressing funding needs. Insurance sector activity has also been relatively subdued, as the deleveraging trend continues. The currency mix for European banks has shifted during the first half of the year, with more activity seen in dollars and sterling versus euros, given the favourable conditions in these markets and the opportunity for issuers to diversify their funding.

Secondly, the importance of ESG has continued to grow at an impressive pace in the bond markets, with around 50% of total issuance in the euro primary market in June having an ESG angle. The increased activity in this segment has also provided the market with a growing amount of data points to suggest that there is tangible evidence of a “greenium”. We have seen some material developments, with almost 30 new European issuers coming to the market, as well as the first sustainability-linked bonds from financial institutions, with German lender Berlin Hyp issuing a senior preferred bond in euros and China Construction Bank issuing a senior bond in dollars. In addition, ESG themes have broadened into the spectrum of subordinated products more prominently, with several banks opting for Tier 2 issuances with an ESG flavour. CACIB has been active in this sector, acting as a joint bookrunner on three Tier 2 transactions in June, for BayernLB, ING and RBI.

And thirdly, in spite of elevated levels of uncertainty, market conditions have been favourable for issuers, and any spikes in volatility or market fears have thus far proven to be only temporary — even in the face of inflation concerns, credit markets have remained resilient. Credit spreads overall have continued to move tighter through 2021, and new issue concessions have remained in the single-digits, while in the case of higher beta products, zero to negative new issue concessions have been fairly commonplace given the hunt for yield and ample market liquidity.

What do you expect for the rest of the year?

Whilst the uncertainties related to the Covid-19 crisis may have largely abated — in developed countries, at least — a variety of political, fiscal and macroeconomic factors could still play a part in creating some downside risks for credit markets. Issuers and investors alike will continue to closely monitor the tone of central banks and the potential read-across for rates and tapering. We have already seen the Fed introduce a more hawkish tone, guiding the market towards rate hikes sooner than previously expected. Although it is unlikely that we will see the ECB move as quickly as the Fed in rate hikes, I would expect a tightening in the extraordinary measures — the TLTRO conditions, for example.

We also have elections coming up in certain countries, including Germany, and this can also reduce the possible windows of issuance. Although these downside risks may persist, the overarching theme of excess liquidity and the need for investors to put cash to work will mean opportunities to access the market will persist, and we can see some issuers taking advantage of this to opportunistically pre-finance 2022 funding programmes. This is particularly true given the need to refinance the TLTRO funding, which could drive more issuance in the coming years, and banks may want to take advantage of favourable market conditions.

We expect issuance from the insurance sector to pick up in the second half of the year, following relatively subdued issuance from the segment in the first part of the year. Here at CACIB, we have a number of important insurance mandates in the pipeline across various geographies and formats that will materialise in the coming months.

The trends we observe in ESG are set to continue to expand across the product spectrum, not only across the capital structure, but also into asset-backed commercial paper, securitisation and derivatives.

Another area where a pick-up in activity for financial institutions can be expected is in liability management, as banks adjust themselves to the evolving regulatory regimes, be that the treatment of legacy instruments, or the transitioning away from IBOR, and perhaps we will see some more transactions aimed at optimising the liability structure as MREL requirements become clearer.

The implementation of the Basel III standards in Europe will also regain focus as more clarity is gained on how the framework will be applied for the EU and the associated ramifications it brings for RWA inflation, capital requirements and MREL needs. Although the impacts are not expected to be immediate, banks will keep an eye on the capital impacts and may look to ramp up their capital structures, particularly in regions where the RWA inflation may be fairly large.

How is CACIB positioning itself for the second part of the year?

We have made some changes in our debt capital markets organisation to build on the strong platform we have at CACIB, and to ensure we are well positioned for the upcoming challenges that are facing the sector. We have recently appointed Cécile Bidet to lead the DCM Financial Institutions franchise, taking over from Christian Haller, who will run the DCM business in Germany and Austria. Cécile was previously in charge of the DCM Solutions & Advisory business, and will focus CACIB’s strategy for financial institutions on the following three pillars:

ESG: We are seeking to leverage CACIB’s leadership in sustainable banking. CACIB has been a pioneer in the ESG space and given the rapid pace of growth in the sector, Tanguy Claquin — who has been spearheading the team for over 10 years — is further strengthening and broadening our team’s capabilities with a number of new hires as we expand our offering to include ESG rating and carbon advisory.

Advisory: I am a firm believer in cultivating long term relationships with our clients, and to further increase our offering within DCM, we are expanding our advisory capacity, with Michael Benyaya and Véronique Diet Offner now leading our DCM Solutions & Advisory team following Cécile’s move.

EUR/USD platform: Finally, our third pillar remains being focussed on our strong euro and dollar platform. CACIB is a leading player in the financial institutions space within debt capital markets, being number one in the league table in 2020 for all financial institutions in euros. We have maintained this leading position in 2021, and have been involved in many high profile transactions in 2021 across both currencies.

The Fed has revised upward its expectations for a rate hike in 2023 and, as explained by chair Jerome Powell, it has started “talking about talking” about a future tapering of its QE. We might be at the beginning of the process of monetary tightening in the US — should the ECB follow the Fed?

As Christine Lagarde has repeated several times, the Eurozone and the US are not in the same situation and, consequently, the central banks must act differently. The difference between the two economic zones lies, in my view, in three factors:

Firstly, the US entered the pandemic in a better situation than the Eurozone: GDP was at — if not above — its potential, the economy was at full employment, and inflation was sufficiently high. On the other hand, the Eurozone was still struggling with the scars of its double-crisis of 2008 and 2011, with elevated unemployment and low inflation.

Secondly, the pandemic has had a harder impact on the Eurozone economy than on the US because of the spread of the virus, but also the measures taken, and to a lesser extent a more efficient start to the vaccination campaign.

Thirdly, and more importantly, the major difference between the US and the Eurozone is fiscal policy: the US government reacted with an extremely strong fiscal response. Whereas the Eurozone, despite the involvement of both national governments and the EU (with the Next Generation EU (NGEU) recovery package), provided a relatively limited fiscal package.

Because of these three elements, US GDP reached its December 2019 level in June 2021 and, more surprisingly, could exceed the pre-pandemic trend in the coming years. On the other hand, the Eurozone is only expected to reach its 2019 level in the second quarter of 2022, and should remain at a low growth trend in the coming years. This largely explains why the two central banks are in very different situations: on the one hand, the Fed is starting to think about a gradual reduction of its monetary support, while on the other hand, the ECB should be increasing its monetary policy support.

You mention increasing monetary policy support, yet the ECB started the discussion about tapering the Pandemic Emergency Purchase Programme (PEPP) at its June meeting — even if it decided against tapering.

With PEPP, the ECB has adopted a new approach to monetary policy. With this tool, instead of providing broad monetary support — like it does with rates and the Asset Purchase Programme (APP), for example — the ECB specifically targets financing conditions. The idea is that during the pandemic period, the monetary stance cannot take the same approach as before. Consequently, PEPP was not created to ease monetary policy, but rather to ensure that financing conditions remain favourable. This was the case at the very beginning of the crisis, when the ECB used PEPP to compress sovereign spreads and revive the commercial paper market, and it is also the case currently, with the ECB using PEPP to compress yields and rates to ensure that financing conditions for households and SMEs remain as favourable as possible.

Under this scheme, the ECB calibrates the pace of PEPP purchases not necessarily depending on the economic and inflation outlook, but rather on financing conditions relative to this economic outlook. This explains why the ECB has from the very beginning of the programme been constantly discussing the pace of PEPP purchases, sometimes to increase it and sometimes to reduce it.

Consequently, a reduction in the pace of PEPP in the future would not necessarily mean a “tapering”, given that it would not necessarily indicate a gradual and definitive end to the programme.

But we can still anticipate PEPP ending at some point?

Yes — and relatively soon, in our opinion. As its name indicates — Pandemic Emergency Purchase Programme — PEPP is strictly linked to the pandemic, so it should no longer exist when the pandemic is over. Now, the discussion at the Governing Council is when the “pandemic period” will be over: is it when the Eurozone will be sufficiently vaccinated, or when the economy will be back to its pre-pandemic level? For me, the pandemic period is longer than that: the pandemic period will be over when the Eurozone economy will have healed from all the scars resulting from the pandemic: with GDP not only returning to its pre-pandemic level, but also having caught up to the potential level that it would have reached without the pandemic. This is the only way to ensure that the ECB has been accommodative enough and that it can go back to its “conventional unconventional” monetary policy, i.e. what it was implementing before the pandemic.

Louis Harreau, CACIB

There is another matter to take into account: fiscal policy. The ECB is calling for governments to implement more proactive fiscal policy to support the recovery, and at the same time, it is warning about the risk of removing fiscal measures too early. Under the current outlook — and even more so if governments listen to the ECB — this means that public bond issuance will remain heavy in 2021, of course, but also in 2022: public deficits will remain large, and we also have to add the NGEU issuance. In this context, the end of PEPP purchases in March 2022, as is currently expected by the ECB, would trigger a demand/supply imbalance and would increase sovereign yields. Not only would this worsen public finance balances, but as sovereign yields are benchmarks for other financing conditions, this would also tighten financing conditions.

That said, this is the theoretical perspective — we know that some members of the ECB’s Governing Council want to end the PEPP as soon as March 2022, because they worry about overly accommodative monetary policy, and also to ensure the consistency of the tools: PEPP was designed only for the pandemic.

What could be the result of this discussion?

For me, the ECB cannot return to its pre-pandemic monetary policy (APP purchases of €20bn a month) before December 2022. This means it has two options: either it increases the PEPP envelope (currently €1,850bn) and extend the programme until the end of 2022, or it ends PEPP in March 2022, as expected, but at the same time increases the monthly pace of the APP to €50bn or €60bn until the end of 2022. The two options would have more or less the same consequences — the idea is simply to absorb part of the net issuance of public bonds. In my opinion, using PEPP more is the simplest option: PEPP is more flexible and the built-in limits of the APP do not bite in PEPP, consequently an increase in the PEPP would be a one-off and would not have longer term consequences on the ability to source enough bonds in the APP.

Regarding the APP, it has been out of the headlines since the announcement of PEPP, but the programme is still running.

Indeed, the ECB continues to buy €20bn of bonds — public, corporate and covered bonds — every month, and the programme is open-ended. Unlike PEPP, this programme aims to bring inflation back towards the ECB’s level. This means that it is likely to continue for a very long time. We assume that the ECB will continue the APP until core inflation exceeds 1.4% on a permanent basis — i.e. the level at which it would start being more comfortable with the inflation outlook. This means, according to our projections, that the ECB would end the APP only at the end of 2024.

Since the ECB explained that, like most central banks, it will end its net purchases before hiking its rates, we do not expect a rate hike before the end of 2025.

This is the basis of our scenario for the ECB’s monetary policy: an intense monetary policy until the end of 2022 — until the end of the pandemic period — with an extension of PEPP or an increase of the APP; then an accommodative monetary policy (with an APP of €20bn a month and a deposit rate at minus 0.5%) until the end of 2024, before very gradual normalisation of monetary policy, with the end of net purchases followed by the beginning of rate hikes.

There is another tool we have not discussed: TLTROs.

Most of the time, TLTROs are underrated by investors and analysts. They have provided extremely strong monetary support to the Eurozone since their creation in 2014, allowing banks to have access to cheap funding in exchange for their commitment to lend to the private economy. During the pandemic, the ECB transformed these tools to make them more efficient, both to ensure financial stability and to enable banks to provide favourable financing conditions to borrowers. Cutting the rates to minus 1% for 12 months and then 24 months ensures that all banks benefit from the same extremely favourable financing conditions. It also encouraged banks to lend more proactively to the private economy. Furthermore, as the operations are collateralised, TLTRO acted as backdoor QE, since banks purchased bonds on the market to use them as collateral at the ECB.

As for the future of TLTROs, we believe it is likely to look like the other aspects of the ECB: as the pandemic recedes, the ECB is likely to stop the extremely favourable operations after the last one, expected in December 2021. However, as with the other tools (APP and negative rates), the ECB is unlikely to stop TLTRO anytime soon. It will probably announce new operations — less favourable than TLTRO III, but still very attractive — in the course of 2022.

We are discussing the modalities of the ECB’s gradual exit from its very accommodative monetary policy, yet inflation is not expected to reach the ECB’s target anytime soon. And that’s without even considering the potential for a renewed crisis to derail the recovery and the increase in inflation. What more could the ECB do?

Two elements are certain. On the one hand, the ECB is not out of options: it can still cut its rates, it can still buy more bonds in its purchase programmes, and, furthermore, with the TLTROs, it has shown that it has no limits in its ability to support credit lending. But on the other hand, it is also clear that all these tools have diminishing returns, and that at a certain point, the negative effects will overcome the positive ones — we are far from this point, however.

There has been a lot of discussion about “helicopter money” or about public debt cancellation by the central bank. We do not believe that these are adequate answers because: they are forbidden by EU Treaties; they would force the ECB to overstep its prerogatives; and, more importantly, they are economically suboptimal.

The true answer to the current suboptimal situation and to a potential future crisis is outside the remit of ECB — or at least, the ECB could only play a part, as it would require cooperation between fiscal and monetary policy. The example of US fiscal and monetary policy during the pandemic is a good guide — and the economic results could provide answers about the efficiency of such cooperation. Fiscal policy supported by a central bank knows no limits as long as inflation does not bite. Consequently, if the Eurozone faces another downturn that would put downward pressure on inflation, coordination of fiscal and monetary policy would be the answer. Of course, the issue for the Eurozone is that there are 19 fiscal policies and one monetary policy. The conclusion is clear: the Eurozone needs more fiscal integration. A first step has been made with the NGEU, but the EU will have to integrate further to face new shocks in the future.

Main photo credit: Martin Lamberts/ECB/Flickr

Although markets have reined in earlier expectations of Fed action since the March meeting, US CPI jumped to 4.2% in April and inflation figures are expected to continue to overshoot in the coming months. Marinov says this could prompt FOMC members to adopt a more hawkish stance at the September meetings, while bringing forward their expectations of future rate hikes from 2024 to 2023 as described in the so-called dot plot.

“By September, the Fed will have an updated set of forecasts with a sufficient number of data points on growth, inflation and labour markets to potentially conclude that less monetary stimulus is needed, and then proceed towards tapering by the end of Q1 next year,” he says.

However, he expects the process to play out differently to the “taper tantrum” in 2013 that preceded the announcement of tapering in December that year. Then, Treasury yields backed up ahead of the official announcement, before gradually falling over the next three years.

Marinov expects 10 year Treasury yields to head towards 2% in early 2022 from around 1.6% today, and remain around that level for some time.

“In the current conditions, the Fed will try to avoid taper tantrum as much as possible,” he says. “I expect some adjustment in rates, but I wouldn’t think it’s going to be as aggressive as what you’ve seen in the past, because since last August the Fed has adopted the average inflation targeting framework, which is by definition more dovish compared to their previous policy stance.

“They could announce that from January they are going to gradually cut the pace of purchases, but remain vigilant and maintain a fairly stable rates outlook, albeit with the new start of the tightening cycle in 2023.”

With Eurozone rates expected to be kept at “rock bottom”, such US developments could lead to a widening of the euro/dollar cross-currency basis swap, which has recently hit historic lows, according to Marinov (pictured), after it widened into March upon earlier inflation fears.

“Global liquidity conditions have warranted very tight spreads,” he says, “but growing divergence in the policy outlook will essentially mean that we could see a renewed rewidening of those spreads.”

Contributing to the recent retightening has been an overhang of liquidity deriving from a $1tr reduction in the Treasury General Account, announced in February, which has kept US money market rates depressed, according to Marinov. He expects the downward pressure exerted by this to ease once the reduction is completed this month.

Meanwhile, a successful extension to the debt ceiling next month and renewed spending by the Biden administration and Treasury borrowing could absorb more liquidity — with the Fed otherwise potentially acting to put a floor under money market rates, if necessary, by hiking the interest rate on excess reserves or signalling a willingness to increase the repo rate, for example.

Higher Treasury yields could also encourage greater foreign demand, which Marinov notes has remained below recent highs despite the return on hedged purchases having improved significantly for Eurozone and Japanese investors this year. The very tight euro/dollar cross-currency basis swap spread at present may nevertheless partly reflect growing demand for short-dollar hedges by Eurozone investors in Treasuries. That said, a potential bear flattening of the Treasury yield curve in the wake of the QE taper announcement could make a significant increase in the demand for short-dollar hedges less likely in the coming months.

Meanwhile, tighter funding conditions in the US could encourage renewed reverse Yankee issuance from US corporates and this could boost demand for dollars in the forward market.

While such factors will put widening pressure on the euro/dollar cross-currency basis swap, Marinov sees potential pressure in the opposite direction from Eurozone corporates selling dollar forwards and buying euro forwards, particularly as the global economy recovers from the pandemic and their export revenues increase — even if this activity has recently come in well below expectations in the first months of the region’s recovery.

Prior to 2020, correlation based on price indices of bank and insurance equity, and of related subordinated instruments fluctuated significantly throughout 2018 and 2019. The evolution of their dependence was quite random, with correlation remaining relatively weak and no signs of any strong convergence between different instruments and asset classes. We believe that in spite of the many equity characteristics of hybrid instruments, the performance of the hybrid market was mainly driven by fundamental credit metrics and central bank measures, and typical equity KPIs already had a limited impact on subordinated debt. During this period, European financial institutions (FIs) were in at least decent shape, even if their low profitability — primarily provoked by an inhospitable, low interest rate environment — was already a reality. Stable economic growth and the significantly improved or sound asset quality of the majority of institutions allowed subordinated investors to sleep easy.

Over the past few months, we have observed an interesting change in the relationship. At the beginning of the year, a substantial increase in correlation could be observed, with a visible and strong convergence across subordinated instruments for both asset classes. We believe that this change was mainly driven by the gradual advance of Covid-19 and particularly accentuated by the World Health Organisation’s declaration of a pandemic and following lockdown decisions in major economies. Plummeting global markets provoked a similar reaction in financial institutions’ subordinated instruments, but subsequently the situation has changed considerably.

Bank and Insurance Subordinated Instruments and Equity: price evolution (since January 2019)

Bank and Insurance Subordinated Instruments and Equity: correlation coefficient (since January 2020)

Key takeaways:

● A substantial rise in the correlation at the beginning of the year — the correlation coefficient reaching the range of 0.85-0.95 for all analysed asset classes
● A gradual decrease of correlation since the Covid-19 outbreak — particularly by Bank Tier 2 (a drop from 0.80 to ~0.1)
● AT1 and RT1 instruments exhibit a very similar behavior in terms of correlation evolution in 2020

Source: Crédit Agricole CIB — see notes below for further details

Since late March, we have witnessed a gradual weakening of the correlation for all analysed asset classes. This phenomenon could in part be explained by all the protective measures announced by the European authorities (reduction of capital and liquidity requirements) and their recommendation that basically forced banks to shore up capital with dividend cancellation (on 27 March the European Central Bank asked banks not to pay dividends or buy back shares during the Covid-19 pandemic until at least October 2020, with a similar statement from Eiopa on 2 April), but also by a strong statement from Andrea Enria, chair of the ECB’s supervisory board, on 8 April: “ECB has no plans to order banks to suspend coupons on their hybrid debt.” Those actions were supposed to help banks and insurers to maintain crucial access to the subordinated markets in an extreme context where equity markets are closed.

Today, this strategy seems to be working. All the capital relief measures and especially the dividend cancellation recommendation mechanistically improved FIs’ credit metrics that again seem to be a major factor for the subordinated market. Consequently, we have seen a dichotomy in equity and fixed income interests.

An interesting observation is the very similar behaviour of AT1s and RT1s — their correlation with the respective share prices came out very similarly, showing that these instruments are perceived very similarly by investors.

Another interesting point is an even more important decrease of bank Tier 2 and equity dependence in recent weeks. The ECB’s statement on AT1 coupons may have been perceived as very strong and reassuring for the interests of AT1 investors, but at the same time the statement has implicitly reduced Tier 2 bonds’ risk and incited an outperformance of Tier 2. Such favourable conditions allowed Commerzbank and Crédit Agricole to execute very successful Tier 2 transactions last week (see related articles).

Even if the correlation between subordinated instruments and equity can be perceived as a quasi-paradigm, we need to be careful before jumping to conclusions about its relevance. We consider that, in today’s opaque and extremely complex regulatory context, other, less straightforward factors weigh on the performance of the subordinated market, even if our perception may be biased by its behaviour during the crisis.

What is your view on the latest ECB moves and what are the next steps you expect from it?

The ECB has gradually implemented a comprehensive and diversified response: (1) it significantly stepped up its purchase programmes, by adding €120bn to its QE programme and by creating the €750bn PEPP; (2) it dramatically entered the commercial paper market, hence avoiding a prolonged and destructive freeze of the short term funding market for corporates; and, more importantly, (3) it improved banks’ funding conditions by easing the TLTRO conditions in several significant ways.

In increasing its purchase programmes, the ECB is aiming first and foremost to ensure that sovereign spreads do not widen too much, which would trigger financial fragmentation and a tightening of monetary conditions. However, because of the programmes’ size and flexibility, the ECB can act discretionarily on any dysfunctional market segment — corporate bonds, commercial paper, covered bonds — and improve funding conditions for all big corporates.

Easing the TLTROs (rate as low as -1%, easing of collateral rules) will ensure that banks are able to grant credit to all economic actors, starting with SMEs and households.

These tools have proven to be effective so far: in spite of the economic developments, sovereign spreads have remained at manageable levels; banks have been able to face the astonishing increase in credit demand without tightening credit conditions; and, in spite of risk aversion, corporate spreads have come down from the peak of the crisis.

The ECB will continue to adapt to market and credit conditions. An extension of the PEPP seems to be a given: at the current pace, the ECB will have emptied the €750bn by the end of summer. On other aspects, the flexibility built into the purchase programmes should allow the ECB to adapt to most foreseeable market developments.

If the crisis were to be deeper and the recovery slower than expected, the ECB would reinforce its structural tools: increase monthly purchases in the QE programme and possibly ease TLTRO III conditions further, for example, extending the very favourable period with rates as low as -1% for the whole length of the operations.

What are the implications of the German constitutional court ruling?

The German constitutional court is more a threat to the EU’s architecture than to the ECB’s monetary policy. Of course, the court called into question the proportionality of the PSPP — a monetary policy tool — but the heart of its decision is rather that the European Court of Justice (ECJ) has not properly analysed the programme and that German institutions (government and parliament) have not exerted enough control over the ECB.

Following the ruling, several European institutions (the ECB, ECJ and European Commission) have rallied and the German government has adopted a constructive tone, which gives us hope that a solution will be found — before the end of the three month period — on the monetary policy side. The challenge, however, will be to make sure that, within this solution, the supremacy of EU law over national courts is guaranteed, which is the only way to ensure that European decisions (whether from the ECB or another body) apply uniformly to the EU as a whole.

On the operational side, however, there is a risk that the ruling — following the December 2018 ECJ ruling — could set limits for what the ECB can to: by highlighting the importance of the limits of QE in avoiding monetary financing, both courts imply that these limits (capital key repartition and 33% ISIN limit) cannot be removed, which could become a concern if the Eurozone needs a more proactive ECB.

Should we expect another Eurozone sovereign debt crisis?

The current crisis will significantly increase public debt in all Eurozone countries, and, worse, according to the latest economic data, the pandemic will increase divergence among countries: the strongest countries (Germany, Netherlands) will better withstand the pandemic and are likely to have a stronger recovery than the weakest countries.

Against this backdrop, the ECB has proven that it is ready to ensure favourable conditions for all Eurozone countries; the ECB is ready to compress spreads to ensure that there is no financial fragmentation in the Eurozone.

Nevertheless, the size of the shock, the dramatic deterioration of public finances and the economic divergences require more than monetary policy interventions. During the sovereign debt crisis, the Eurozone added several limited tools (ESFS, ESM, SSM, SRM) to the ECB’s support (OMT, VLTROs), which was enough to calm down the crisis, at a very elevated economic cost; this time, we think, the Eurozone cannot avoid providing a more comprehensive response — including a sort of debt mutualisation and fiscal transfers — or those responses will not be enough, no matter how the ECB is involved.

Bank+Insurance Hybrid Capital: 2019 did not unfold as might have been expected at the beginning of the year. What are the key takeaways from the past 12 months?

Vincent Hoarau, Crédit Agricole CIB: 2019 has been a year of surprises. A year ago, in December 2018, markets were discounting three rate hikes in the US and one rate hike in Europe over the next 12 months. Precisely the opposite materialised, after an unprecedented reversal of monetary policy in the US in early 2019 fully restored confidence that stimulus was coming. Central bankers did away with quantitative tightening, in a prelude to the revival of asset purchases in capital markets.

On 12 September, outgoing ECB president Mario Draghi duly confirmed the introduction of a tiered deposit rate, with its modality suggesting that interest rates could technically move lower than the current minus 0.50%. Markets reacted positively to the prospect of lower rates for a longer period of time, while in the US the balance sheet of the Fed was again growing. Draghi also managed expectations extremely well with the announcement of Quantitative Easing #2 and surprised with less than was anticipated. The market was expecting greater QE (some €40bn-€50bn), but there are simply not enough bonds to buy. What the ECB delivered with the announcement of “only” €20bn was remarkable. Markets appreciated the fact that one of the main objectives was more or less achieved: lowering the cost of spending for (southern) European governments and flattening the long end of their yield curves.

Globally, the overall compression of government bond yields and credit spreads observed throughout 2019 was also supported by the absence of new bad news and the fact that the two major political headaches that dominated H2 2018 and H1 2019, i.e. the US-China trade war and Brexit, had less impact in H2 2019.

In December 2018 we wrote that “the ECB could review its interest rate rise commitment … and this could give succour to the market”. We were certainly right, but we never thought 10 year swap rates could trade as low as minus 30bp and the 10 year Bund as low as minus 0.70%.

What are the key risks to current levels?

Hoarau, CACIB: The US economy is buoyant, with good momentum. So the risk of disappointment is high. The next earnings season will again be decisive for rates and the market’s medium term direction. In this context, overpriced growth stocks are a risk for the market, and we don’t see how an equity market correction would not impact the credit market. At the moment, too many people care too much about stories and narratives and neglect cashflow and profit generation. What does the WeWork debacle mean for peers and global markets? Some situations remind us suspiciously of the 2010-2013 period.

But more importantly, near term, we scrutinise the risks involved in the macro/geopolitical side of the equation, and the uncertainty over trade policy. This can damage global growth durably. After a dramatic escalation over the summer, talks between Beijing and Washington resumed and fuelled strong momentum in Q4. On that front, a “phase one” trade deal by January will reduce investor fears of a global downturn and support a strong start to the year. A negative outcome would be critical for markets.

Staying in the US, in terms of risk factors, the Fed could also prove to be more reluctant to cut rates during an election year even if the macro backdrop deteriorates — another key element in terms of potential market drivers. Elsewhere, the risk of a deterioration in the trade relationship between the US and Europe in 2020 is also on the table, and this is certainly where the next surprise could come from. Finally, Brexit could also have a stronger impact than expected, while Italian politic risks, currently dormant, could resurface.

How is the market poised for the January reopening? How should issuers go about approaching the new year primary market?

Hoarau, CACIB: The markets have priced in only good news. The post-summer credit rally was mainly driven by the prolongation of loose monetary policy across the board and strong fundamentals in the US. Investors have subsequently demonstrated a fairly high level of complacency, sending credit spreads to historical lows and equities to new highs in a very liquid market. President Trump’s most recent pronouncements towards a possible longer and wider than expected trade war could make investors less amenable in January 2020. This could fuel the return of volatility on the equity and rate fronts, even if economic data points remain strong in the US

Pressure on senior non-preferred/HoldCo new issue premiums and spreads could materialise in January on the back of the resurgence of primary market supply. Why should issuers wait when spreads are at historical lows and the senior preferred-SNP subordination premium is as low as 15bp-20bp in core markets? In higher beta, the playground should remain supportive. The AT1 market is structurally undersupplied — particularly in euro-denominated format — so the lower-for-longer rates narrative should support valuations further, while net supply will remain limited.

At the other end of the credit spectrum, the covered bond arena should also benefit from the new situation and remain fairly immune from what may come to pass. With €2bn-plus a month in terms of net purchases and almost €4bn of redemptions to be reinvested by the Eurosystem in January alone, the sector will remain well bid. We also bet on the return in force of opportunistic covered bond buyers, with plenty of liquidity to invest in primary in order to buy bonds they can then recycle with the central banks in the secondary market. The unlimited backstop bid from the Eurosystem is there to stay. Covered bond spreads will therefore remain firm, with supply likely to be well skewed towards long and very long maturities. At the shorter end, decisions over tenor are likely to be driven by the evolution of outright yields. Yes, negative yields work, but the quality of the order book can deteriorate rapidly. We therefore expect issuers to be mindful of the decreasing granularity of order books when the yield on offer turns too negative, and to choose tenor and timing accordingly.

What do you expect in terms of sub debt/bank capital supply in 2020?

Hoarau, CACIB: AT1s outperformed every other asset class in 2019, and for the community of issuers the direct result of this has been the possibility of refinancing existing debt at lower coupon and/or reset spreads. We expect the reset/coupon complex to continue to be favourable for issuers and encourage the refinancing of the existing stock at the first call date. In terms of net supply, it will be limited. Banks have filled their buckets and the forthcoming supply is likely to be to refinance redemptions when bonds are called. The demand/supply dynamic should also support Tier 2 debt, in spite of the expected increase in supply coming from Asia-Pacific. Net supply will remain limited, with a decent amount of redemptions and calls throughout 2020. Gross issuance in euro Tier 2 reached €30bn in 2019. It should not exceed €20bn in 2020, while call amounts are in excess of €10bn.

Funding needs in senior non-preferred format will continue to move within a low to mid-single digit range for individual issuers, and both SNP/HoldCo should reach €160bn across EUR/USD-denominated formats in 2020 versus €180bn in 2019.

What good news could be on the horizon?

Hoarau, CACIB: While the ECB lacks ammunition, Christine Lagarde will likely focus on structural reforms during her mandate and increase pressure on European governments to work on budget policies. So far, the ECB has managed pretty well to reduce the volatility of funding costs for private as well as public sector issuers. The greatest challenge for her will be to connect monetary policy to fiscal policy, i.e. to orchestrate the shift from unconventional monetary policy measures to structural reform and fiscal action. The good news would be to finally see progress on that front after Draghi paved the way during his eight year mandate and bought time for markets. A good scenario would be indeed to see governments following up with a programme of spending. Indeed, over 10 years, Germany is paid 30bp to borrow, while France can spend for free.

● Half year 2019 results showed that the market environment and the low interest rates exerted meaningful pressure on the solvency position of insurance companies. For example, duration gaps in France and exposures to mortgage spreads in the Netherlands appear indeed extremely painful through the S2 lenses. As expected, the drop in interest rates during Q3 has weakened S2 margins, in particular life insurers’.

● Yet the S2 margins still remain relatively strong and generally well positioned in the target ranges (see chart below). Insurers are therefore unlikely to launch cash calls on the equity markets. However, as further pressure is expected (as shown below by the sensitivity to interest rates), revisions to the S2 targets cannot be ruled out in the short to medium term.

● Financial flexibility in terms of S2 capital headroom is strong across the sector. This has allowed companies to tap the debt capital markets to boost the solvency position (see preceding article). In this context, the deleveraging trend has probably come to an end and financial leverage ratios will probably increase again.

● However, the use of subordinated debt has to be viewed as a temporary fix. The adaptation of business models and/or the regulatory framework will be needed to ensure the long term resilience of the sector. In France, several companies have already announced that the access to the general account will be restricted and crediting rates will decrease sharply. There are also some discussions on technical adjustments in the S2 framework of the treatment of specific provisions (e.g. Provision pour risque d’exigibilité in France) that could have a positive impact.

● In terms of regulation, the debate around the 2020 review of the S2 Directive will be fierce, in particular regarding negative interest rates in the standard formula and the volatility adjustment.

 Please click on chart to enlarge.