You can download a pdf version of this article in the full BIHC Briefing alongside further coverage.

Neil Day, Bank+Insurance Hybrid Capital: What impact are the German fiscal package and any other developments since the ECB cut rates 25bp on Thursday of last week likely to have on the development of its monetary policy?

Louis Harreau, Crédit Agricole CIB: Unfortunately, the press conference of the ECB was too early to take fully into account the announcement of the German fiscal package. However, you already had a lot of uncertainties — regarding the next moves from the US administration, and also regarding the outlook for the Eurozone economy, which has been disappointing over the last quarters — and at the same time, inflation is still too high. That’s why the ECB has been non-committal and why Christine Lagarde emphasised that the ECB will remain super data-dependent. So there was nothing new in the press conference. Maybe if it were now, there would be some change in the communication. In her speech a couple of days ago, Lagarde emphasised that we are in a time of great uncertainty and reiterated that the ECB has to be data-dependent, to react to negative developments, but also to upward pressures on inflation, wherever they come from.

Our official call remains the same, that the ECB will cut in April and then it will be done. But things are currently moving relatively quickly and we believe that the German fiscal package will have a significant impact on the Eurozone economic outlook, starting with Germany, naturally, but also for the Eurozone as a whole. Consequently, the ECB could perhaps be encouraged to be more hawkish than was expected a few weeks ago. It would have to include this new element, this positive external shock in its macroeconomic projections, with probably higher GDP growth for Germany and the Eurozone, and possibly higher inflation, not necessarily immediately, but in the medium to longer term. We are awaiting some direction from ECB members as they digest the new scenario, and can probably expect a more hawkish communication in the coming weeks — if I am right and the impact of the fiscal package is as important as our estimates imply.

We were already more hawkish than the market, which is pricing a more dovish view on the ECB, still expecting almost two rate cuts by the end of this year, rather than only one. But we are all taking some time to adapt to this new environment, with the worries regarding tariffs on the one hand, and the hopes regarding the German fiscal package on the other.

Day, BIHC: Indeed, there are a lot of moving parts. Valentin, what is your view on the aggregate implications for Eurozone growth of the US and European developments?

Valentin Giust, Crédit Agricole CIB (pictured below): This is a good point, to try to compare the relative significance of tariffs and the fiscal package, mainly the infrastructure element. I would highlight two aspects here.

Firstly, that tariffs are significantly more uncertain than the fiscal package right now. We are putting a significant probability on the German fiscal package passing, on the amounts being discussed getting done. Yes, there are some risks, but the probability of getting something significant is relatively high. Regarding tariffs, it is much more difficult to have a proper view on that. There may well be tariffs, but Trump has announced many things, only to go back on them, and it’s very difficult to follow what is happening. So in terms of certainties, tariffs are significantly more uncertain than the German fiscal package, and, most importantly, the infrastructure plan.

Secondly, even if you consider tariffs being implemented, in that case, the relative weight of the German infrastructure package is higher than tariffs. If 25% tariffs are implemented — if the US puts 25% on everything and the Eurozone applies equivalent counter-tariffs — we estimate that the negative growth effect for the Eurozone is likely to be 100bp, more or less. It may be slightly more for Germany and slightly less for France, for example, but overall, we are talking about one percentage point of growth that will probably be lost over the next one or two years. When it comes to the German fiscal package, we are talking about probably some additional GDP this year, not necessarily too much — perhaps 20bp, 30bp or 40bp — but we are easily talking about something like 100bp next year, and more for the years after. So if you take the medium term view, and if you look at what could be the situation in 2030, for instance, I think that the trade war has a significantly lower impact than the German fiscal package. The trade war is completely significant, absolutely, but the German fiscal package is so large, and especially the investment and infrastructure plan, that it is outweighing tariffs for the moment, based on what Trump has discussed. So, bottom line, the aggregate implications are positive.

Day, BIHC: You have stressed the importance of the infrastructure element in your answer, whereas headlines are being grabbed by the defence element. Are markets misjudging the relative importance of the two, or is defence perhaps just mentioned as a more sensationalist way to refer to the overall dynamic?

Giust, Crédit Agricole CIB: Currently, it’s very difficult to disentangle everything, to be honest. The defence side is extremely important, because we are talking about geopolitics, we are talking about Ukraine, and it has big implications, far beyond Germany’s domestic situation, the sluggishness of demand, and so on. But at the end of the day, what will mainly impact the European economy is not necessarily the war in Ukraine, is not necessarily defence. This will be something absolutely crucial for that industry, but we are talking about an industry that generates less than 1% of Eurozone GDP.

On the other side, we are talking about the infrastructure plan that Germany needs, that basically every EU economist, except some in Germany, have been advocating for the past 15 years or so, since the sovereign debt crisis, to invest in Germany and stimulate aggregate demand in the Eurozone. They did not decide to do so at that time, so they had a huge current account surplus. Currently, Germany — alongside China — is providing a huge amount of savings to the rest of the world. The German one is particularly invested into the US and this is not sustainable or satisfactory for Germany. There has been, I would say, a reawakening about this situation — probably linked to Trump, JD Vance in Munich, and the like. The Germans are in a very bad place, but they have huge financial firepower and are increasingly motivated and ready to use it. That is very good news.

The infrastructure plan is absolutely critical and we expect it to have at least three to four times more impact on the German and the European economy than the defence spending plan. So when considering the outlook for growth, just look at the German infrastructure plan; the defence plan is absolutely critical, too, but we are talking about geopolitics and security, not about economics to the same extent.

Day, BIHC: What implications does all this have for the relative performance of euro and US assets, and what are financial markets indicating?

Valentin Marinov, Crédit Agricole CIB (pictured below): A big part of what we are seeing in the development of euro-dollar is, as FX investors would say, more euro buying than dollar selling. This is also evident from the fact that the euro trade-weighted index has rallied really quite strongly after hitting lows late last year. There is a lot of optimism on the FX investor side with respect to what the efforts on the fiscal side could do to the economic outlook in Germany and outside Germany. Quite a few people I’ve been speaking to are just fed up with the noise coming out of the White House, and certainly want to focus on the more tangible guidance coming out of Berlin, Brussels and elsewhere in Europe, and its impact.

That said, a key question is whether the rally in euro-dollar has captured most or all of the positive impact. And if not, then how much further can we go? On fundamentals, we expect any change to the growth or inflation outlook to be rather incremental. Tariffs would have a much more immediate impact, but the positive story that we’ve been discussing so far will take potentially years to play out. The yield on the 10 year Bund is currently at 2.88%, but 3% by the end of this year is now in sight, so you would argue that at least on the yield side, there is at least some scope for repricing on the back of that growth optimism. And Bunds yields could further close the gap with Treasury yields. So essentially, part of the positive news is priced in, but not all of it. And coming back to what Louis highlighted at the beginning, the market at the moment is still going for 2% as a terminal rate for the ECB, and our view is at least 25bp higher than that. The fiscal package and growth optimism could certainly push market expectations in that direction, so the current rate spread for euro-dollar may be a little insufficient, and could move again in favour of the euro as the markets converge to our view.

The initial euphoria, around the announcements out of Germany and Brussels, is certainly baked in the cake when it comes to euro-dollar. Some further upside may be likely, but maybe more on a six to 12 month horizon. $1.12 is the upside risk to our current $1.07 forecast. We’ve been consistently above consensus on euro-dollar throughout essentially the last two years — never as bearish as the market — and that call continues to serve us well, but we believe that the appreciation of euro-dollar we are expecting for 2026 will need to be frontloaded into this year. In the interim, the next three to six months, the picture is slightly more mixed. Again, upside risks to our current projections, but only modest, because alongside the need for markets to converge to our views, there are some certainly cross-currents, as just mentioned: we have tariffs, a trade war, developments that at least historically have been negative for euro-dollar, so we could be more rangebound.

Day, BIHC: After the ECB last week, we have the FOMC in the coming days — any update in your view on expectations for the Fed?

Harreau, Crédit Agricole CIB: Yes, we have recently been revising our view, based on the new political news we are seeing, but also on the fact that core inflation in the US is stickier than what we expected a few months ago, and consequently we now expect the Fed to continue gradually its cutting cycle but at a slower pace than expected. That’s also consistent with the ECB and Christine Lagarde saying that they are more data-dependent — we expect the US central bank to be more cautious in its cutting cycle, and also to adapt to the fact that you could have some upward inflationary pressures that the Fed itself did not expect a few months ago. So we expect the Fed to cut in June and again in September.

Day, BIHC: What are the implications of the European developments for asset swap spreads?

Harreau, Crédit Agricole CIB (pictured below): Even before the announcement of the German fiscal package, we saw the ECB’s monetary stance, and especially policy regarding its balance sheet, having a significant impact on the EGB market and on asset swap spreads. This phenomenon is by no means over. There is renewed talk in the market that the ECB could restart its quantitative easing, or at least to stop its quantitative tightening — we don’t believe it at all. The ECB will continue returning bonds to the market — never selling them, but stopping reinvestments, so more bonds being absorbed by the private sector in the market. Consequently, such assets have lower values, so higher yields, and hence tighter asset swap spreads. This German fiscal package could put even more weight on EGB curves, starting with Germany, of course. A continuation of the phenomenon is therefore to be expected, and possibly an acceleration due to this potentially huge issuance in the EGB market from Germany. The market has already priced in a lot, but the movement is not yet over — and that’s also true of the repo market, where we have seen an increase in short term rates due to the fact that market is pricing more collateral in the market and less liquidity because of the ECB’s balance sheet policy.

Day, BIHC: Taking a broader view, liquidity — together with the carry — has been one of the two strong supports of the credit market, but is set to become less relevant as you describe and as SSA supply picks up, leaving spreads vulnerable. How might that unfold?

Harreau, Crédit Agricole CIB: The ECB has been very clear about the process of reduction of its balance sheet — it has communicated well in advance and hence it’s extremely predictable. That’s the good news. The bad news is that, as we saw in the fourth quarter of last year, the market is sometimes non-linear in terms of reaction. Asset swap spreads were relatively steady, and suddenly there was an immediate tightening when the market seemed to acknowledge the ECB’s quantitative tightening. The story will probably be the same in the future: some underreaction to a certain extent over time, then suddenly an overreaction. And my view is that, although it is still some way off, we are getting closer and closer to liquidity scarcity, and as we do so, volatility in these assets could increase. However, the timing is, unfortunately, extremely uncertain.

Michael Benyaya, co-Head of DCM Solutions and Advisory, Crédit Agricole CIB: Following the recent decisions from the Fed and the ECB, where exactly do we stand in the interest rate and inflation cycle?

Bert Lourenco, Head of Rates Research, Crédit Agricole CIB: The picture is quite different if you look at the Eurozone in certain respects relative to the US.

With the US, we think that Trump policy clearly makes it quite challenging to figure out what’s going to happen next in many respects. For example, just last week, as a by-product of the recent tariffs, we’ve kind of bumped up our US inflation forecast a little bit. But generally we think that the current level of rates as embedded in the market is pretty much fair, so we see the Fed stopping at 4%, maybe we don’t get a cut as soon as we thought, but it’s kind of consistent with what we have in terms of the market terminal rates around 4% and 10 year Treasuries hovering around 4.5% as well. I’d say there is risk to the upside for US inflation, which would probably mean that the Fed would hesitate to cut this year still relative to what we have forecast. Nobody’s really talking about Fed hikes yet, but that is a scenario for which I don’t think there’s a zero probability. And with regards to fiscal policy, again, we have to see what the full impact will be and how that gets transmitted to the bond market. So we think Treasury yields could rise a little bit, but capped below 5%.

For the Eurozone, right now we have a situation where the market’s looking for rates to go lower than our own forecast, of 2.25%, and I think that reflects fears that people have on the growth aspect and how that impacts inflation, which is gradually approaching the target. On the inflation side, we could have some small upside surprises for the next few months. It’s really the second half of the year where we think inflation will come back fully towards target. We see 2% headline inflation around July.  So a slightly different path on inflation and policy rates, but nothing too different from what the market’s got priced in. Bunds around 2.5% look like fair value. To us, opportunities lie more in spread products, and we don’t see reason for aggressive bets with regards to the curve or duration.

Benyaya, Crédit Agricole CIB: You mentioned the Bund spread — what can we expect for the spread complex for Eurozone govvies?

Lourenco (pictured), Crédit Agricole CIB: If you look at how much longer we’re going to have QT for in the Eurozone — and it’s in place for the US — we’re talking about possibly another two years. And if you consider the risks of what the German elections might bring, in terms of the possibility of the debt break being removed or relaxed, then our view continues to be that Bunds will remain an underperforming asset. For Germany, the fundamentals don’t suggest there’s strong reasons to believe that things can change in the next few quarters in terms of poor growth.  To us, this implies that over time Bunds gradually lose their allure as a safe haven asset relative to the rest of the EGB complex. So we think that Bunds will keep underperforming swaps, for example, with the Bund curve steepening relative to swaps, and at the same time, we think that the periphery will continue to grind tighter, as long as there’s no big credit event.

And really the credit market is central, especially with regards to BTPs, which can continue to bring the spread compression to tighter levels. There isn’t anything on our radar in terms of political risks in the periphery at present. Even in France, we think the situation is messy but manageable. So we’re also looking for more compression of OATs versus Bunds, believe it or not, and that, I think, will just be a gradual process. So overall, still positive on the periphery. It doesn’t seem like there’s any big risks out there for now. The big thing to be careful of would be a change in the credit cycle in the US and the credit markets, but that’s just not on our radar given the policy mix and large deficits.

Benyaya, Crédit Agricole CIB: Let’s move on to Florian and covered bonds, where swap spreads have been a major topic lately. Can you share with us what the latest sentiment is on this, taking into account the thoughts you have heard from investors on your travels?

Florian Eichert, Head of Covered Bonds and SSA Research, Crédit Agricole CIB: Regarding swap spreads, investors agree with Bert on the direction of travel, but typically not in terms of the extent of the move. Also, Bert, you mentioned economic fundamentals, you mentioned Germany possibly losing its allure as a risk free asset. Well, from most of the investor meetings I had, there is no shift in terms of what investors see as the euro risk free asset. After all, where else are you going to move to in euro markets? French sovereign bonds? They have been reasonably volatile these past months. The European Union is filling that position at the moment, of course. However, it is probably not going to be around in size long enough to really take on that position in the long term.

Hence, at the end of the day, yes, you have the issue of an increase in the Bund free float, with the ECB balance sheet run-off, even without any discussions around new elections and amendments to the debt break. And that, I agree, is continuing to put pressure on Bund-asset swap spreads. However, I have come across a lot of investors from pension funds to bank treasuries and real money who would add Bunds in size if they were to trade as wide as 30bp-35bp over swaps.

For the SSA and covered bond spread complex, this means that no one expects spreads of the European Union, KfW, or, in a second instance, covered bonds at the long end to go meaningfully tighter versus swaps. The floor from Bunds has just shifted up to a level where you cannot expect to move back to the pre-Covid days with covered bonds trading flat versus swaps, or the EU 15bp-20bp through swaps. In fact, further widening and steepening of Bunds versus swaps will keep investors cautious towards long end SSAs and long end covered bonds. Investors do not expect Schatz to move, they do not even really see Bobl move in size. Hence, if I look at the covered bond space, further Bund weakness is a story, but it is not one that would be extremely disruptive. The disruptive part, we have already seen in Q4 with Bund asset swap spreads collapsing, also in five years. But if you expect Bobl to trade flat to swaps, that’s another 5bp-7bp only and the pick-up you have in both SSAs and covered bonds versus Bunds is big enough to then only have a marginal move wider in terms of spreads versus swaps. In other words, we are fairly well-protected from here, especially in the area where we have seen the biggest amount of activity in covered bond markets.

In other words, to me, it is above all a long-end story and it is above all a European Union story as the issuer has size to do and needs long tenors. Banks, on the other hand, do not have the funding needs to be pushed into the long end, and they look at these spread levels almost as a personal insult, and therefore will not issue long-end covered bonds that could reprice their curves.

Benyaya (pictured), Crédit Agricole CIB: I was about to ask about the implication for supply forecasts. You have already specified a few elements, but more broadly, what do you expect for the covered bond market in 2025?

Eichert, Crédit Agricole CIB: We have had a few years with the European Central Bank offering banks very, very cheap three year liquidity, and as a result of this, we had two, three years with very little covered bond supply. As we got to the end of the TLTROs, of course, they had to be refinanced. So we had undershooting of supply, followed by two years of overshooting in 2022 and 2023. Last year and this we are back to the more traditional classic factors driving supply. What happens on your asset side? What do you have in terms of redemptions on your liability side? And then, how do the various liability products price relative to each other? At the moment, we look at a market where there’s virtually no loan growth across many European countries and deposits are really sticky. So there’s limited overall needs on the funding side. Take Crédit Agricole as an example, the bank has a €20bn funding target for this year, after starting last year with €26bn. In addition to this, we have a market where the Bund ASW and EGB spread complex seems to have been relevant for rates buyers only, with the credit world not focused on any of this at all. This has led to performance of senior, senior non-preferred, Tier 2s even in Q4 last year when covered bonds were struggling. As a result of this, banks are actively choosing to not issue secured funding product, but to start the year with unsecured debt because the relative pricing between the two has become very tight. Hence, we are massively behind where we were last year in terms of covered bond supply. I think it will pick up gradually as we go further, but the main drivers on the balance sheet dynamics are just not there to justify huge amounts of issuance.

Benyaya, Crédit Agricole CIB: Cécile, from the origination side, following up on these covered bond dynamics and looking more broadly at funding and the capital structure, what can we expect for 2025?

Cécile Bidet, Global Head of FIG DCM, Crédit Agricole CIB: Florian has already covered a number of the drivers, asset-liability, so on, funding, indeed limited needs. Our view is that overall, the funding is going to be stable this year. One of the parameters is MREL, because even if banks don’t need liquidity, they have capital requirements. Most banks, and Greek banks included, are already more or less at their MREL target and are relatively well optimized on capital, too. So, it will be again redemptions that will drive the market. Same as last year, AT1 and Tier 2 will be a big component of the market. Last year we were around the €40bn mark on AT1, and around €50bn on Tier 2. And for this year, we’re seeing almost the same thing, between €35bn-€40bn, both for AT1 and Tier 2. And again, this is driven by redemptions, because the risk-weighted assets are not growing that much. Asset side is sluggish, and we also don’t have a lot of impact from Basel IV. At the moment, it’s very much manageable. It’s been absorbed by TRIM in the previous years. We will see a little bit more from Basel IV when the output floor kicks in for a number of banks. But at the moment, the risk weighted asset growth is relatively limited. So yes, we see MREL refinancing driving the issuance, with capital still being very much dominant. We’ll see if, in terms of spread, we still have the same compression as we saw last year.

Benyaya, Crédit Agricole CIB: Exactly, that was my follow-up question in terms of funding conditions. Spread convergence has been a key theme in the credit markets. What is the relative positioning of Greek banks now? And do you expect these dynamics to continue or to stabilise?

Bidet, Crédit Agricole CIB: So that’s the big question. And Greek banks were definitely the top performer in the market. I think on Tier 2, we saw the spread compression of around 200bp on average in 2024 — that’s absolutely massive. This being said, when you think about the premium senior-subordinated, there is still a wider premium than for other countries. So yes, there is still a little bit of compression that is possible, but we will not see what we’ve seen since 2023 when the compression started.

We have this compression also because the fundamentals are improving massively. We saw that in the rating. I often say that ratings are a lagging indicator; I think this time, they’re doing a pretty good job in keeping up in terms of upgrades. Also hoping that on the sovereign side, there will be some positive news from Moody’s at some point. And that will also help for the covered bond rating.

Benyaya, Crédit Agricole CIB : Let’s move on to addressing the topic of ESG. I don’t want to be controversial, but we have all seen the North American banks leaving the Net-Zero Banking Alliance. Cécile, what is your feeling around ESG and the funding strategies of European banks? Where does it fit at the moment?

Bidet (pictured), Crédit Agricole CIB: ESG remains a very important topic in Europe politically, and not only: in terms of society, too. And I think that European banks are committed to their decarbonization strategies, and ESG funding is a thing that will remain. It’s very important. It definitely helps in terms of diversification of the investor base. It also helps in terms of performance in the secondary market, because we all know that you have much more demand from ESG funds than there is in terms of supply. In fact, when a fund needs to rotate a portfolio or get some liquidity, the last bond that they will sell is your green bond. So definitely a lot of advantage. And I think that ESG is here to stay for the diversification of funding. It also depends on market participants.

You mentioned some banks leaving the NZBA and the impact of that. It depends on issuers and market participants, if they care about ESG, making sure that they deal with a bank that is still in the alliance in order to make a difference. We all have a say and, maybe I’m a bit biased, but I think it’s important that market participants recognize that some banks are staying in the alliance to make a difference, and you need to validate them on those topics.

Benyaya, Crédit Agricole CIB: Florian, on your side, anything to add on ESG labeling for covered bonds? Does it bring any specific benefits?

Eichert, Crédit Agricole CIB: It depends on market conditions. At the end of last year, we had a really weak market, with covered bond transactions struggling. At that time, banks were shifting their green assets from unsecured transactions to covered bonds to de-risk these transactions. It was not about saving extra basis points, not to have a second curve that trades different to the conventional one — that we don’t even have on the Bund curve — but it was to de-risk trades and ensure market access. Early this year, we are rather looking at limited covered bond supply and squeezed markets. Hence, there is no point in adding a green or social angle to covered bond transactions. Whether you have an eight times oversubscribed book, or ten times by going green/social, does not really change the equation for you as an issuer. Hence, banks have gone back to refocusing their green supply to unsecured trades. So it simply depends on market conditions to determine what banks use these assets for. At the end of the day, banks still only have a limited amount of assets identified on their balance sheet that qualify for their ESG frameworks, so it’s always about deciding where they are needed the most.

Benyaya, Crédit Agricole CIB: Let’s now move to the final part of our discussions: what risk factors do you see for the rest of 2025? Or perhaps you want to share a word of optimism?

Lourenco, Crédit Agricole CIB: I’m always optimistic, which is why I always have a slightly higher yield forecast than many of my peers. I’m not necessarily surprised people are worried about Trump’s policies, but for assets the reaction needs to reflect a lot of future moving parts. It doesn’t have to be catastrophic. It’s just a question of adjustment of trade flows and their composition. And I think applying a geopolitical lens for that sort of analysis kind of implies that Europe is not necessarily going to be at the eye of the storm relative to other cases, like China.

Eichert (pictured), Crédit Agricole CIB: To me, it is hard to think of risk factors from within the covered bond space that could become a bigger problem. Bank profitability may be past its peak, but banks are in good health, with solid capital, liquidity and funding metrics. Covered bond supply will pick up as we move further into 2025, but I do not see a risk of over-supply. Cover pool asset quality may deteriorate marginally, but concerns on the investor side are predominantly limited to commercial real estate backed programmes, of which we have only a few, in Germany. Hence, I am more concerned around exogenous factors. If Bert were to be correct on his Bund-ASW forecast and we get 10 year Bunds trading 35bp over swaps, then we would clearly get pressure on long-end covered bond valuations.

In terms of positive surprises, if the investors that I speak to are correct on Bund-ASW, then we should be close to a stabilization in Bunds. And if we then add the possibility of less rather than more European Union funding, we take away another disruptive element, especially on long-end covered bond spreads. In the first half of this year, the EU is still aiming for EUR90bn of funding, hence the entity is at peak supply and peak volatility. If the EU were to realize in the second half of the year that they are still waiting for disbursement requests from Spain, they will struggle to maintain the current funding pace. Materially less supply from an issuer like the European Union is positive for long end SSA spreads and this in turn may also give covered bonds a bit of extra wiggle room.

Bidet, Crédit Agricole CIB: Last year, all the stars were aligned, technicals, fundamentals, and the market ignored geopolitical risks, political risks, too. I agree with Florian that on fundamentals we are going to see a bit of net interest margin deterioration because interest rates are cut. Maybe cost of risk is going to increase a little bit, but this is absolutely manageable, within the through-the-cycle range, and this is more than mitigated by the strength of balance sheets. Liquidity, capital are extremely strong — I don’t think that the banking sector in Europe has been ever that strong. So fundamentals are going to be fine. The only risk for me is on the technicals. At the moment, we have abundant liquidity, and since Q1 2023, we’ve seen continuous, positive inflows in credit funds.

The question is, what happens in H2 when interest rates are cut and investors have alternatives to invest in, and the flows stabilize or become negative? We’ve already seen a slowdown in ESG investor flows — for the first time, in Q3 2024, ESG inflow was lower than the conventional funds. And that’s my only concern: when the paradigm is not sufficiently compelling that you have to invest in credit because rates will have been cut.

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Michael Benyaya, co-head of DCM solutions and advisory, Crédit Agricole CIB: To set the scene, what is the central scenario for the Eurozone economy? And do we foresee a recession for 2024?

Bert Lourenco, global head of rates research, Crédit Agricole CIB: Relative to other houses, we are somewhat more optimistic, and even within CACIB, I’m probably more optimistic than my colleagues. We don’t expect a recession this year. In fact, we expect growth to pick up — still sub-trend, but just below 1%. What are the reasons for this?

First and foremost, we had a terms of trade shock for the past few years, led by the energy crisis, and that’s clearly unwound itself. This is leading to the current account changing from a deficit to a surplus for the EU in general. Secondly, we still have pretty strong labour markets — which is pretty astounding — and these labour markets are still generating wage gains of 4.5% or so, so we think that real household incomes will increase, giving household consumption a boost. And then we have this phenomenon that is pertinent around the world, not just for Europe, which is that we have deficits, and these deficits seem to be structurally persistent. So in aggregate, governments have less net issuance this year, but when you throw in the EU and supranational issuance, that actually becomes a net positive, so we also have support through the fiscal side. When you bring all this together, that’s quite a good combination for a broadening out of growth.

One final thing to mention is the juncture of banks with the real estate sector. High interest rates have not caused as much pain in residential real estate as one might expect. There are pockets in the EU, like Sweden and Germany, that still have some pain to come in real estate. But overall, banks seem to be in pretty good shape, able to provide credit if there’s demand, which is pretty amazing given the level of rates we have right now.

So it’s really a matter of subdued, but better growth across Europe — but remembering that Germany is going to remain the sick man of Europe for a while, and so we should not depend on the German manufacturing sector to lead growth in Europe for some time at least.

Benyaya: In terms of the financial institutions primary market, what have we seen in the first two months of 2024? And how does it compare with early 2023?

Vincent Hoarau, head of FIG syndicate, Crédit Agricole CIB: Since the beginning of the year, the primary market activity in euro-denominated format has been very robust, around €140bn. Nonetheless, down 18% year-to-date versus 2023. Last year’s volumes were exceptionality high; 2024 volumes are still up 35% versus 2022, and twice the volumes of 2021. So far this year we have enjoyed issuance activity in line with what should be a reasonable pace in a normalised world post a decade of QE.

If we look at issuance in US dollars, it is exceptionally high, with numerous jumbo offerings from Yankee banks. This time last year, funding in US dollars was less competitive in terms of arbitrage for European banks; nonetheless, Yankee issuance is down 10% this year versus last.

Elsewhere, European issuers also continue to be active in sterling and niche currencies, looking to further diversify their funding sources. Lastly, on ESG, issuance is down 30%, but still up versus 2022.

In terms of demand and investor reception, the tone is particularly supportive and all the metrics we look at around deal execution have been great. Oversubscription levels are exceptionally elevated. The stickiness of demand when we adjust pricing lower in bookbuilding, the granularity and the quality of order books are great. Secondary performance post pricing can be impressive. New issue concessions have been drifting tighter since the beginning of the year, and are sometimes non-existent or even negative.

All those things point to a very healthy market. Investors love the current level of yields. The iTraxx financials is currently at a two year low.

Looking at the profile of issuance, in senior unsecured, tenors are well spread across the maturity spectrum. In covered bonds, 50% of supply has come with a maturity between five and seven years. Last year the average duration for funding was shorter than five years. The growing appetite for long dated assets is remarkable. We have seen much more 10-12 year new issues this year compared to last.

We see the most noticeable change across funding instruments in the covered bond space. 2023 was a record year in terms of issuance, but a very challenging one for covered bonds, a year during which the asset class digested the legacy of a decade of quantitative easing. The market has been dealing with ongoing technical distortions because of the lack of relevance of secondary market spread levels, which were kept artificially tight sometimes because of the purchases of the Eurosystem. After a year of repricing across jurisdictions, we started 2024 with much healthier trading metrics. Globally, the product has become much more appealing, while the buyer base has grown steadily. That’s a relevant evolution for FIs.

Benyaya: You mentioned that spreads are tight — why is that in the current environment?

Hoarau: A couple of elements explain the current spread complex. First of all, the demand side of the equation is supported by a very robust economy in the US, while the situation in Europe is improving significantly, particularly in the South and to some extent in France, even if we have the aforementioned situation in Germany. We also have a very favourable credit environment in spite of the string of rate hikes over the past two years. We have not seen a lot of credit events — yes, we had Credit Suisse and the US regional bank issues last year, but away from that the market has been extremely resilient. Over the past 12 months, we have enjoyed a very nice situation in terms of ratings evolution, with a lot of upgrades and many financial instruments moving from non-investment grade to investment grade. So that’s the first element.

The second element explaining why the spread complex situation looks really exceptional, is that the equity rally is also pushing pension funds to rebalance cash to the benefit of the credit market. And if you screen the world of investment grade credit funds, we continue to see tremendous inflows.

But most importantly, the yield environment combined with the excess liquidity situation is certainly what is keeping spreads so tight nowadays. And as long as the liquidity situation does not change, we are going to see a market that remains extremely resilient, and any sign of correction will very likely be short-lived. In this very particular rate environment, there is little upside in selling bonds, particularly high coupon bonds. And the recent negative headlines around commercial real estate for the time being remain isolated cases that are not derailing the market from its very strong path.

Benyaya: When it comes to the spread complex for Eurozone government bonds, and also ECB monetary policy, what can we expect?

Lourenco: At the start of the year, many people were looking for the ECB to start cutting rates even as early as Q1 of this year, which we thought was way, way premature. Our view is for three rate cuts in Q4, i.e. after June, and three rate cuts in the first half of next year. We think the ECB needs a lot more evidence to be fully comfortable that inflation is coming back to target, and that their fear of a policy mistake still points towards moving more slowly in cutting rates. And nobody’s going to be in a hurry to cut in large amounts — unless we have a recession, a hard landing — therefore, we foresee 25bp increments. The market still has a bit more than that priced in. So if you ask me what our view is on the rates side, we still think that yields can go up a little further, simply because we think the market’s got a little bit ahead of itself — you have a 25bp cut effectively priced in for June already, which we think is too early. And remember that they will come out with their forecasts in March, June and September. So really we think that more time is needed, and that the forecast in September will allow them to proceed with that cut.

Coming back to the first question, on the spread complex. What could lead to massive spread widening in EGBs? It could result from redenomination risk, but that doesn’t seem to be credible from a political angle for any country right now. It could possibly come from a big deleveraging event that sharply increases unemployment. Or counter-cyclical factors that result in a sudden deterioration in government finances. But these factors aren’t at play.

Our view — which is a little different than a year and a half ago — is that in spite of hikes, and in spite of QT, we have not been worried about spread widening. Why? Number one is that we have high nominal GDP. This is the impact of inflation. So government tax receipts are very good everywhere. That will be a supportive factor. Number two, high yields create demand. We’ve seen a transition away from institutional investors more to retail investors being interested in fixed income — just look at all the retail products coming out of Italy, Portugal, and now places like Belgium. So higher yields are not an impediment to keeping spreads tighter — we do still think that significantly higher yields leads to a bit of spread widening pressure, but nothing dramatic. So we don’t have the ingredients for the massive spread widening that people were so afraid of at the start of the cycle. If I’d asked a year and a half ago if you believed that spreads would be at these levels with the ECB having hiked rates 400bp and unwinding its balance sheet, you’d have said, no way. But that’s exactly what’s happened, and that’s actually a pretty good thing. I think the ECB has done a pretty good job along the way, which is a slow, well-flagged pace of QT, and at the same time creating the the perception, at least, that there are mechanisms in the background such that if dramatic spread widening happens, it can step in at any point in time. All these factors probably point towards any spread widening remaining modest. Lastly, I would mention that the general abundance of liquidity and performance of credit, with a lack of defaults, also supports this view.

Benyaya: How are expectations regarding ECB monetary policy affecting investor sentiment and investor positioning?

Hoarau: The paradigm has changed completely in 2024 versus 2023: at the beginning of last year, we had the end of the tightening cycle ahead of us; in 2024, we have the start of the easing cycle ahead of us. So while the management of monetary policy risk was on everyone’s agenda in 2023, it has been losing a lot of its relevance. Investors now feel much more relaxed towards any type of risks. They like the yield, and while they may dislike the spread, they just enjoy the carry, disregarding the timing of the first rate cut. I can imagine that at some point one or the other may lose patience. But for the time being, I would say, so far, so good. And we are in a situation, a very unique situation, where the relationship between rates and credit is inverted.

Benyaya: Staying with interest rates, but looking at it from a slightly different angle, banking ALM: we’ve seen the higher interest rates boosting net interest margins in some countries — not everywhere, but in some places — what could be the hedging strategies to maintain this type of net interest margin?

Yves Glaser, head of financial institutions advisory, EMEA, Crédit Agricole CIB: Indeed, in the southern part of Europe — Greece, Spain, Italy, Portugal — banks generally grant variable rate mortgages, although there is a recent trend towards a higher proportion of fixed rate loans. In the northern part of the euro area — France, the Netherlands, Belgium — banks tend to lend at fixed rates. In France, for example, typically more than 90% of production is fixed rate and for very long periods, 20 to 25 years. ALM likes a natural match between assets and liabilities. That’s a factor contributing to a shorter model on the liability side for banks in Italy and Greece. Overall, the duration of balance sheets in southern Europe is lower than in northern Europe, which makes net interest income more sensitive to a change in interest rates. Given the rise in market interest rates, the development of NII for retail activities in these countries has been very favourable.

As rates fall, banks with low balance sheet duration will lose this benefit relatively quickly and return to lower levels of NII. The question for ALM teams now is: is this a good time to increase balance sheet duration and lock in the benefit of current interest rate levels?

One welcome development is that the beta on deposits has been relatively low over this period. It has been a good stress test: we have had almost a 400bp rise in rates and overall, while there has been some decline and some outflows on demand deposits, it has been relatively limited. Customers have been much less reactive on their deposits in this rising rate environment than they have been on their mortgages to prepay when rates went down. This would argue in favour of increasing the duration of deposits.

Once you increase the duration of deposits, how do you increase the duration of assets to effectively get more stickiness in your net interest income? The first way would be to do a receiver swap. But historically, banks with a high proportion of floating rate loans have tended to use their liquidity portfolios to increase the duration of their assets, and not so much receiver swaps. So a natural way to extend the duration of assets and immunise NII against lower rates would be to buy forward bonds, thereby locking in the reinvestment rate of maturing bonds. In addition, buying forward bonds rather than doing a receiver swap will benefit from the fact that the EGB curve is steeper than the swap curve. Finally, hedge accounting of forward bonds is easier than for a swap because the forward bond is an all-in-one hedge, the hedge item is the bond that you will receive, whereas for a swap, a commercial item would be designated as the hedged item, with potential inefficiencies arising from basis risk or behavioural risk.

Finally, some banks are also looking to buy floors to protect their NII against lower interest rates. In the same spirit as buying forward bonds, buying a call on government bonds can be an efficient alternative to a floor, both financially given the shape of the curve, and operationally for hedge accounting. Also, in terms of P&L profile, buying a call may be more suitable as the time value would be recorded in the initial period when NII is at a high level, whereas for a floor this time value would go to the P&L over the entire maturity of the hedge.

Benyaya: In terms of banking supervision, I know that there is a 200bp stress test set out in the regulation, but you mentioned we have experienced well above that. Do you have a view on how this could develop?

Glaser: The regulatory stress of 200bp was supposed to be the 99th percentile of interest rate stress, so once in 100 years, and we have had a 400bp move in interest rates. A revision of the stress level is currently within the scope of the regulator. In addition, we have had in the last two years bank failures as a result of interest rate risk, in particular SVB. This is another incentive to review the regulation. Pablo Hernández de Cos, chairman of the Basel Committee, gave a speech on the subject in September last year and raised the issue of IRRBB being in Pillar 2. However, moving IRRBB to Pillar 1 would be a very long shot. In addition, at the end of that speech, he also mentioned that these failures were more related to poor risk monitoring by these institutions than a structural problem for the banking sector which is related to Pillar 2.

In any case, we could see some changes in regulation, and in particular in the level of interest rate stress. Currently, there are discussions about extending the stress from 200bp to 250bp, which could be significant for some retail banks that manage their interest rate exposure close to the limit. Supervision is also likely to focus more on the IRRBB models used by banks, especially on deposit outflows, as large deposit outflows were the trigger for the SVB failure.

Benyaya: Let’s turn to sovereign ratings, where we have seen some divergence among countries. What is your view on such rating developments, also with reference to the Greek sovereign?

Lourenco: As a general observation, credit ratings don’t really give investors much of an advantage, because rating agencies are very much backward-looking. That doesn’t mean that they’re not important, simply because ratings are used by investors to invest in other domiciles, by risk management committees, and even for investors, they provide a kind of anchoring for valuations. They are also used by CCPs, for example, and as such give a kind of indication of what the value of such collateral might be. That’s a roundabout way of saying that you cannot ignore them.

Having said that, there are many metrics rating agencies look at, but crucial is if you’re running surpluses or deficits on the fiscal side, and likewise for the current account. There are a few countries in Europe that have these twin surpluses, while a few have twin deficits. Those with twin surpluses are Greece, Portugal and Ireland, and these are the smaller countries that have positive ratings momentum. We think that they’ll still be subject to upgrades in the future, as long as we don’t get a massive recession and there’s no big deleveraging event. Meanwhile, the bigger countries with twin deficits are those we are a little more worried about, such as Belgium and France. We’re not so concerned about Italy or Spain for the time being. That’s how we differentiate among European sovereigns. So we would still be positive on Greek developments given what’s happening here at a fundamental level.

(See ratings focus below for more on Greek upgrades.) 

Benyaya: On the back of this positive momentum in Greek sovereign ratings, how is Greek risk perceived in the credit markets?

Hoarau: People are chasing Greek assets. The rating trajectory of the country has been decisive in spread developments for the country. Investors are really impressed by the pace of the reforms, and how austerity has paid off in recent years. It’s not about cleaning balance sheets now; good banks are again on the offensive. And we could have further good news from Moody’s this year on the sovereign, with the ratings of Eurobank and NBG benefiting. In any case, the trajectory of Greek metrics are clearly reflected in the evolution of spreads in the secondary market: over the past 12 months, Greek senior bonds have tightened by an average of something like 200bp. When I’m looking at headlines nowadays, with what’s happening in Germany compared to what’s happening in southern Europe, it’s quite a turnaround.

Benyaya: Before we open the Q&A to the audience, one final question to each of our panellists on risk factors for the rest of 2024. Yves, as alluded to earlier, clearly interest rate movements can result in some arbitrage strategies by clients and depositors. How is this risk factor reflected in banks’ interest rate risk management, and do you see any potential changes in the course of the year?

Glaser: During the decade of very low interest rates, we have seen a surge in sight deposits in almost all countries. I like to look at the ratio of sight deposits to household disposable income. For a long time this was very stable — from the late 1990s to around 2010 — but from 2012, when interest rates were zero or negative, the ratio started to rise and by 2020 it was more than double what it was at the end of 2010. So we clearly have a lot more demand deposits now relative to household disposable income. And so far we have seen relatively low deposit outflows. This situation may not last, as there is no reason why customers should be less efficient today than they were 20 years ago. It takes time for customers to regain a deposit culture. Deposit outflows may also continue if interest rates remain at current levels. On the other hand, if interest rates return to lower levels, we may see an increase in prepayments on recently sold fixed rate mortgages. So there is certainly quite a significant behavioural risk on balance sheets. The supervisory teams are looking at this very closely, reviewing banks’ IRRBB models and requiring them to incorporate hypotheses about arbitrage from non-interest-bearing to interest-bearing products.

Banks have developed models that link the stability of deposits and the level of prepayments to the level of interest rates, which is a good response to this uncertainty. They are trying to hedge this exposure to behavioural risk. We see this in the demand for options products.

Benyaya: Bert, not another question on interest rates, but one on inflation. I believe inflation forecasts have been relatively sticky. What are the risks to these forecasts given that inflation seems to be easing somewhat?

Lourenco: First of all, I’d note that one of the things that makes us a little bit different from other research shops is how much time and effort we spend analysing the inflation side. With the ECB having a strict and, I should stress, symmetrical inflation target, inflation developments are uppermost in our mind in terms of how we think about the market.

For this year, we expect the decline in inflation to proceed, but it might not proceed as fast as the market has priced in. We think it’ll be a little bit higher than implied, particularly in the CPI fixings for the second half of the year. At the start of the year, we thought inflation would probably come in at 2.5%-2.8%, although following some better developments recently, we’re probably talking about around 2.5% HICP on average for the year. Two factors explain this higher inflation. One is tight labour markets, and wages, which imply that service wages stay high — as I mentioned earlier, we have wages growing at around 4.5%, so core inflation will by default stay high. And then the other thing that we consider a lot is food price inflation, simply because of what’s happening with the climate, the cost of food production — just look at the farmers’ protests across Europe. These two factors to us imply that inflation will probably be a bit higher than others expect.

The last point I would make is that a lot of people are looking at inflation dynamics returning back to what they were before Covid, and we’re not so sure about that. It could be that we have sufficient changes in structural factors, be that industrial policy, changing global trade patterns, particularly Asia and China, potentially the implications of green energy investment, more military spending and so on, and continued pro-cyclical fiscal spending. These kinds of structural factors imply that, this time around, we don’t expect inflation to be below 2%, we think that it will stay somewhere around 2% going forward. It still means that the ECB can cut rates, but it means that we’re not going back to a low inflation environment like we had in the past, and probably not a very low rate environment, either.

Benyaya: Vincent, what risk factors do you foresee for the FI primary markets for the rest of 2024?

Hoarau: I’m fairly bullish, I have to say, at least for the first half of the year. If I have to list some potential risk factors, I would start with a theoretical one, which is the increase of Minimum Reserve Requirements by the ECB. This could push up supply and increase potential pressure on spreads, but I think this risk is only theoretical as long as the liquidity situation remains intact. More important, and later in the year, could be refinancing risk driven by booming SSA supply and the refinancing of ballooning budget deficits. And clearly reflation risk would be a disaster for markets. This is certainly improbable, but if we have no rate cuts this year, and a narrative grows up around rate hikes instead of rate cuts, it could derail the market from this very strong base, and this is something we are all bearing in mind.

Benyaya: Thank you all for your insights. So now I’m happy to open the Q&A session.

Audience member: Going back to the regulatory environment, if I’m not mistaken, there’s a focus on the credit spread risk for the banking book, something that might become mandatory or at least that the regulator is monitoring. How do you see the banks in Europe working on that? And what’s your view on the final outcome?

Glaser: That’s a tricky question because I don’t think there’s a consensus on how to track credit spread risk in the banking book. It’s a new requirement from the EBA to have a risk framework for CSRRBB and there is a lot of reluctance on the part of banks  to have a generalisation to the entire banking book.  There are heterogeneous practices but I think that many banks have a restrictive view on the scope of CSRBB, which is mainly limited to their bond portfolio and does not include the loan book. On the liability side, I don’t think banks include their funding spread in the scope of CSRBB. Having their own credit spread in the scope of CSRBB would mitigate the stress on the asset side. The ECB would probably be reluctant to have this attenuation factor in case of a widening of the credit spread. So far, it is probably mainly been an appreciation of the bond portfolio’s exposure to credit spread widening.

Audience member: You haven’t discussed the possibility of Trump being elected, or all the other elections taking place this year. What are your thoughts on this front?

Hoarau: That could be a factor in why I’m more bullish on the first half of the year rather than the second half… When it comes to the direction of spreads and risks for markets, it’s primarily a question of liquidity and market absorption capacity. Then we look at geopolitics and that element can go with the liquidity dynamic and refinancing risk if the question around European defence funding comes up. In the US, the fiscal lever will be heavily used either way. But one scenario potentially implies more pressure on the issuance front in Europe, and potentially on the spread complex in the lower beta part of the borrower spectrum (government and supra).

Lourenco: The way I look at it is that for markets, what matters is the politicians’ positions on deficits, and be it Trump or be it Biden, the reality is that neither seems committed to bringing down the deficit substantially. Large deficits by definition imply high nominal GDP, and if you have high nominal GDP, that’s by definition good for risky assets and for markets in general. So we shouldn’t overplay the impact of the difference between the two, as it’s not that big in terms of what it means for the fiscal equation. As for one being more pro-business or against it, the perception is probably that Trump’s more pro-business. What that implies for global trade, sanctions and so on, that’s a different question.

Audience member: How would you assess the second round effects of the increase in wages for inflation?

Lourenco: If wages keep increasing, service inflation will stay high. And household real incomes should get a progressive boost, which is actually good for the growth equation. Quantifying this is quite difficult, but if we continue to see wages above 4%, continuously, that just means that other factors within the inflation mix will have to come down. So it just delays the easing cycle. Does it imply that we get hikes? I’m not so convinced that’s going to be the case. If we had high wages for a long period of time and a supply shock — with oil prices increasing dramatically, for example — that would really change the market’s perception of what the ECB will be doing.

Bank upgrades eyed in wake of sovereign’s

After more than a decade in sub-investment grade territory, Greece was in the autumn rewarded for reform efforts by receiving a series of upgrades that saw it finally regain investment ratings, with only Moody’s yet to take this final step.

S&P was the first of the “big three” rating agencies to upgrade the sovereign back into investment grade territory, lifting it from BB+ to BBB- on 20 October 2023.

Implementing a stable outlook, the rating agency cited an improvement in public finances thanks to budgetary consolidation efforts, noting that since the debt crisis of 2009-2015, significant progress has been made in addressing the country’s economic and fiscal imbalances.

“We expect additional structural economic and budgetary reforms, coupled with large EU funds, will support robust economic growth in 2023-2026 and underpin continued reduction in government debt,” said S&P.

Fitch followed suit on 1 December, also lifting Greece from BB+ to BBB-, on stable outlook. High among key rating drivers cited by the rating agency were favourable debt dynamics.

It noted that a projected decline in the debt to GDP ratio of 65pp, from a pandemic high of 205% to a forecast 141.2% in 2027 would be among the best performances of any Fitch-rated sovereign. The rating agency acknowledged that the ratio is forecast to remain close to three times the BBB median, but said mitigating factors such as low debt servicing costs, very long maturities (18 years) and a substantial liquid cash buffer (around 16.5% of GDP mid-November) reduce public finance risks.

A commitment to fiscal consolidation was the other factor uppermost among drivers of Fitch’s upgrade. The primary surplus was set to increase to 1.1% of GDP and average 2.2% in 2024-2025, according to the rating agency’s forecasts.

“Fiscal prudence is anchored in conservative expenditure assumptions in recent budgets (and is also the case in the 2024 budget),” said Fitch, “with revenue over-performance providing fiscal space for temporary spending: in 2023 this included energy crisis and climate change-related measures.”

With Scope Ratings having upgraded the Greek sovereign from BB+ to BBB- in August 2023 and Morningstar DRBS having lifted it from BB (high) to BBB (low) in September, the next move from Moody’s is awaited. A Moody’s upgrade in September left Greece on the cusp of investment grade, at Ba1, on stable outlook, although the rating action was by two notches, from Ba3. The rating agency cited several factors that could lead to an upgrade.

“A continuation of economic policies and commitment to fiscal consolidation, together with successful implementation of remaining reforms, particularly in the judicial system, leading to greater resilience to external shocks, faster than expected improvement to fiscal strength and work-out of non-performing loans (NPLs) would support a higher rating,” said Moody’s. “In addition, a more rapid change in Greece’s economic structure that helps to improve economic resilience would be credit positive.

“Further improvements in the banking sector,” it added, “reducing volatility of profitability and bringing asset quality and capitalisation ratios closer to the euro area average, would also be credit positive.”

Moody’s two notch upgrade of the sovereign was accompanied by an improvement in its macro profile for Greece from Moderate- to Moderate+.

This contributed to the six Greek banks rated by Moody’s benefiting from one or two notch upgrades in the wake of the sovereign’s, with all on positive outlook.

You can download a pdf version of this article in the full BIHC Briefing alongside further coverage.

Neil Day, Bank+Insurance Hybrid Capital: The market seems quite bullish regarding rate cuts, and this has driven primary market activity at the start of the year, but we have had mixed signals from data and central banks lately. What are the key risks on this front?

Valentin Giust, Crédit Agricole CIB: Looking back at the past year, expectations regarding 2023 were revised substantially. A year ago, the consensus for 2023 US GDP growth was about 0%, but now we expect something around about 2%-2.5%, which is an outstandingly large and positive revision. And the US economy is still quite hot — it is slowing down, but only very gradually.

There are two main forces compelling the Fed to remain quite hawkish — indeed, we were quite surprised by the Fed in December, with Powell’s rather dovish tone. The first is the fiscal deficit, which is still quite significant, with the deficit to GDP ratio above 6% over the last 12 months — this is akin to a recovery plan on the still overheating economy. At the same time, the household saving rate is very low, which helps the US consumer continue its very strong pace of consumption and the very positive retail sales we’ve had since the summer, as evidenced by last week’s print.

Consequently, we are not convinced that inflation will return to 2% very easily in the US. The first mile has been achieved quite easily, but the second one will be much harsher. We mainly believe that we are in a “no landing” scenario. The labour market is still too tight. It is slowing down, but the imbalances — mainly excess demand over supply on the labour market — are still significant, so we still expect some wage pressures, above 4%-5% per year this year as well as in 2025. That’s why we expect US inflation to remain at an annualised rate of around 3% this year, and why we expect the Fed to remain quite hawkish this year, at least until summer. We currently expect just two rate cuts this year, in July and November. We are discussing this call and whether we will add an additional cut, but we clearly lean towards the hawkish side of the market as far as the US is concerned.

Day, BIHC: So would you expect a repricing at some point?

Giust, Crédit Agricole CIB: We need to see some repricing across the whole curve, and especially the short term part, because some of the cuts that are currently priced in have to be de-priced. A first cut in March or April as anticipated by the market is completely out of touch with macro reality. There would need to be a huge downward revision of growth for the central bank to be in a position to deliver such a cut, and we do not expect that, which is why we rather expect the first cut of the easing cycle to occur in the summer. The picture is not dissimilar for the ECB, but I will let Louis comment on that.

Louis Harreau, Crédit Agricole CIB: Indeed, this parallel between the Eurozone and the US can be drawn. The repricing in relation to both central banks seemed to occur in one go and to have been something of a self-fulfilling phenomenon. As far as the ECB is concerned, markets are way too optimistic about rate cuts. The pricing in of a rate cut in April is very unlikely to be proven right.

The Eurozone economy may be in a different situation than the US, but core inflation is much stickier than what the market is currently pricing. Even if you can have volatility in terms of headline inflation — due to energy prices, etc — core inflation should remain sticky. Wage pressures in the Eurozone are continuing to build due to the tightness of the labour market, and this will be transmitted into price rises. Consequently, we expect inflation, and especially core inflation to remain above the ECB’s target permanently, if you will, or at least until 2026. In this context, we expect — as for the Fed — the ECB to keep its rate at the current level for significantly longer than what the market is expecting.

This means that at some point in time there will be a repricing of the market. What we find surprising is that the ECB’s pushback against current market pricing over recent days and weeks is not being listened to by the market. Most ECB members have explained more or less clearly that they do not intend to cut before this summer, at least — so we could discuss if it will be June or July, but certainly not April. On the way down, markets have been very eager to price in rate cuts when there were any dovish comments — for example, Isabel Schnabel’s interview with Reuters on 5 December surprised on the dovish side — but now ECB members can be as hawkish as they want and the market is not listening to them. So the risk is that you could have a significant repricing at some point in time — although it is not yet clear what could spur this repricing.

Day, BIHC: What impact might geopolitical developments have, for example and perhaps most topically, the attacks on Red Sea shipping?

Giust, Crédit Agricole CIB: There are many geopolitical risks — regarding Taiwan, regarding Iran and the Red Sea with the Houthis, as well as the Ukraine conflict, which has not gone away. So we are facing a very difficult geopolitical environment and this is a source of inflationary risk, with the risk of a negative supply shock. We believe that the current market pricing of inflationary risk coming from an exogenous supply shock is very low, and that some repricing shall be needed.

There is a second part to this story, namely the US election. We believe Trump could also be considered as an exogenous negative supply shock risk potentially bringing inflationary pressures. A victory for Trump would be positive for US demand — we could see a new recovery plan, a new tax cut scheme, or something like that.

So there are many inflationary risks around the corner and market pricing is nowhere near reflecting these.

Harreau, Crédit Agricole CIB: The Eurozone is particularly exposed to geopolitical factors, such as the Red Sea tensions, and obviously the Russian invasion of Ukraine due to its proximity. So unfortunately the Eurozone is likely to be more exposed than the US if there is a worsening of geopolitical issues.

When it comes to elections, the outlook is better. Since the beginning of the pandemic, the Eurozone is no longer a geopolitical or political problem per se. The Eurozone is not the source of the problem. There will be important European Parliament elections in the middle of this year, but if you look at projections, there’s no reason to be especially worried about them: even if the number of populist MEPs may increase, they should remain in the minority. So again, the EU and the Eurozone should not be an issue; it will rather face exogenous issues.

Day, BIHC: Apart from the rate cut question, should we be watching out for any other significant moves from the ECB, in terms of TLTROs or QT, for example?

Harreau, Crédit Agricole CIB: Let’s be clear: we don’t expect QT or any acceleration of QT with PEPP in the second half of the year to have any meaningful impact on anything. The reduction of the ECB’s portfolio is extremely slow, possibly too slow — we could discuss that, but this means it will have probably no impact on the market whatever happens.

On the contrary, the end of TLTROs still holds some uncertainties. We have to acknowledge that the repayments of TLTROs have been extremely smooth so far: it has had no market impact and banks have faced no difficulties in getting the liquidity they have needed. But there’s still the possibility that repayment of the last €400bn of TLTRO monies that will have to be repaid in 2024 could be more complicated. The banks who have not yet repaid their TLTROs are probably those who most need the ECB’s refinancing operations, and that’s why it could be more complicated for them to replace the ECB’s term funding by market funding. So you could have some limited tensions from specific banks when they have to repay their TLTROs and when their TLTROs will no longer be NSFR-eligible, i.e. when the longest one falls below six months. I’m by no means talking about a banking crisis or whatever, but there could be some idiosyncratic issues for specific banking institutions.

Day, BIHC: Taking a longer term view, perhaps into 2025, do you have any thoughts on the prospect of a comeback for QE at some point, given the ballooning supply and possible question over how this will be absorbed without a significant repricing?

Harreau, Crédit Agricole CIB: There are several dimensions to this very interesting question. The first is the market’s absorption capacity.

The second touches on the question of the neutral rate for central banks. Indeed, we have the feeling that neutral rates have to be significantly higher than prior to the pandemic due to structural changes in the economy. So market rates will have to adapt to the new supply-demand imbalance in the bond market overall.

And the third point is related to the issue of the US election and specifically the funding of US debt, and Valentin can cover that together with the first point.

Giust, Crédit Agricole CIB: Here, our assessment for the US is quite different than for the Eurozone. In the US, there is a clear issue when it comes to stabilisation of public debt and its long term trend. Issuance is rising and at the same time there is no clear political platform to deliver consolidation in the public finances. That’s why we expect public debt issuance to continue rising year over year.

Meanwhile, we can discuss whether or not the capacity for this to be financed externally remains as it was pre-Covid. The US current account balance is substantially negative, about $1 trillion per year, and the US has to find this externally. The main three financers are Germany, Japan and China, and it is reasonable to doubt both the capacity and the willingness of those suppliers of excess savings to continue financing the fiscal deficit and the external deficit of the US. So while the funding needs of the US are projected to grow over the next 20 years, there is a question mark over the capacity of savings globally to absorb this, resulting in a funding gap. In theory, this could lead to the emergence of some term premia on the US dollar curve.

But at the same time, the Fed’s approach to QT normalisation is very different from the ECB’s. While in the Eurozone space, as Louis said, the ECB is willing to keep up with QT, the Fed is willing to slow down its QT — we expect the Fed to reduce its QT in the second part of 2024, and then stop its QT and just sterilise its balance sheet from some time in 2025. This will not mark the return of QE, but we can therefore expect some kind of end to QT, and this will help offset the effect of term premia in the US. So while we can be cautious about the US long end, you have this Fed support.

In the Eurozone, we don’t have this pessimistic outlook, but at the same time we don’t have the ECB to sustain the market.

So at the end of the day the situation on balance will be quite similar, but the reasons across the pond are very different.

Main image copyright ECB/Felix Schmitt

A pdf version of this article is available here.

Bank+Insurance Hybrid Capital: Since your new issue may have represented many European fixed income investors’ first encounter with AIA Group Ltd as an issuer, perhaps you could start by providing a brief portrait of the group?

Ethan Farbman, AIA: First, I want to thank you for the opportunity to discuss our profile and particularly the recent transaction.

AIA Group Limited is a pan-Asian life and health insurance company with a platform that has been built for over a century. Our market capitalisation is approximately $136bn, making us the largest life and health-focused insurance company in the world by market capitalisation. The business was founded in Shanghai in 1919. We became an independent and publicly traded company in 2010, listed and headquartered in Hong Kong, ticker 1299 HK.

The group is entirely focused on the Asia-Pacific region and has 100% ownership in 17 of our 18 markets. Notably, in 2020 we became the first and only company to be granted a wholly-owned foreign life insurance subsidiary in Mainland China. Since IPO, the focus on Asia and our financial discipline have been the foundation of the group’s extremely strong balance sheet and our consistent delivery of profitable growth. Our profitable growth is illustrated through an increase in both the group’s embedded value (EV) equity and shareholders’ allocated equity of more than three times since IPO.

BIHC: Why have you decided to enter the euro market, debuting with this subordinated trade, and how does it fit with your overall issuance strategy, notably your dollar presence?

Farbman, AIA: We have been a fairly regular issuer in the US dollar market since 2013, active in both the 144A/Reg S market and the Reg S-only market. Previously, we had been exclusively issuing senior debt, but last year we shifted to issuing subordinated debt. That shift was driven by regulatory change in Hong Kong, with the introduction of the group-wide supervision (GWS) framework. This was enacted in March this year, but it had been in the works for some time and the rules for debt capital instruments were near final in summer 2020, which allowed us to begin issuing subordinated debt from last September onwards. Our issuances since then have all been subordinated, and we expect our issuance going forward to consist largely of subordinated debt.

The euro market is of course a large international investment grade debt market, and one where many financial institutions — whether they be banks or insurance companies — issue sub debt. In light of our shift towards subordinated debt, and being a fairly regular issuer, and a large cap company by international and not just Asian standards, issuing into the euro market is something that we feel adds financial flexibility through opening up for us a new deep market.

We have close relationships with a number of European banks who have been informing us about the euro market and updating us on market opportunities. We also have some very large investors — whether they be asset managers, insurers or sovereign wealth funds — that are global institutions who manage across different currencies, including dollars and euros, and some of those had in the past expressed an interest in seeing us in euros. Entering this market was something that we had been thinking about for some time. We felt confident that there would be a large number of new high quality investors that we would be able access in euros.

From a timing standpoint, it seemed right, with markets being very constructive. This was the case globally, but particularly in Europe. The rate and spread environment is obviously very low, and we thought that it was the right time for a new name to be well received by investors and achieve an attractive cost of subordinated debt funding.

BIHC: The structure of your Tier 2 instrument has been viewed as more akin to a European bank Tier 2 than insurance Tier 2 — what are the relevant elements and why is it structured this way?

Farbman, AIA (pictured): This is more driven by AIA’s capital structure and current levels of leverage, which provide us with a degree of flexibility. In terms of the Hong Kong regulatory framework, the requirements for regulatory capital are more debt-like than what rating agencies require to get equity content and capital credit. Most insurers tend to structure regulatory capital instruments that also achieve rating agency benefits, such as equity content for managing leverage, or more capital credit if the rating agency has a capital model. We have done that in the past, and we will do it in the future, but we also have the flexibility to be able to issue structures that only receive regulatory capital credit, like a 12 non-call seven. We only have 13% leverage — that’s total leverage, not financial leverage and we have very strong credit ratings, with our capital adequacy scores from all three credit rating agencies at the highest end of the spectrum.

We chose to issue the 12 non-call seven because we we have the flexibility to be able to, and because we felt like that was the more appropriate instrument to lead with in a new market, as people could really focus on the credit. While it’s a subordinated instrument, there was no requirement from any price discovery around structural features such as coupon deferral, ultra-long maturities or extension risk.

BIHC: What were the key messages you wanted to convey during premarketing about AIA and the issuance (beyond anything already mentioned)? What did investors focus on?

Farbman, AIA: We had a mix of investors that were familiar with us and many that were new. One thing we needed to make sure of on this marketing exercise, unlike past ones, was to take a step back and introduce the company, introduce our strategy, the fact that we are pan-Asian, and exclusively focused on Asia, which is the most attractive region in the world for life insurance, with substantial amounts of growth.

We did receive a number of questions on the deal structure, similar to what you just asked before — why can we issue this type of instrument that is so infrequently issued by insurers? We addressed these questions largely in relation to our conservative capital structure with low leverage, extremely high interest coverage, and very strong financial strength ratings.  The discussion naturally led to questions around our solvency capital levels, which was 412% as of 30 June 2021, and the Local Capital Summation Method, or LCSM approach, that has been adopted under Hong Kong’s new GWS framework.

BIHC: How do you feel the transaction went? How did the execution, pricing and distribution compare with your hopes and expectations?

Farbman, AIA: The process went very smoothly. One thing that we were aware of going into the trade was how busy the calendar was going to be — there was a lot of competing supply, a lot of other issuers in the market — so we did have to take into account that we were going to be asking people to join a series of calls and that it was going to take up more than just one day of their time. The announcement went out on Tuesday morning, European time, and we managed to get together a schedule that was very good, we did a couple of calls that day in the afternoon, and then a number of calls the following day. On the Wednesday we had close to 40 investors sign up for the various calls, and the banks and ourselves were also engaging with a lot of others who were providing feedback and considering the deal. So the marketing process was very smooth.

On Thursday morning we went out with initial price guidance of 140bp. We knew the final level would be tighter, but we didn’t know by exactly how much — our expectations were for perhaps 20bp-25bp — so the final outcome of 110bp may have surprised us a bit to the upside, but that was entirely supported by a book that at peak was about €4.4bn, with numerous triple-digit orders. We were expecting the reception to be good, but we were pleasantly surprised at just how big the book was and how many high quality investors came in. We were very happy with the level of demand and the final pricing, and we’ve been very pleased that the bonds have continued to trade well in the secondary market, which is good for us and good for investors.

BIHC: What can investors expect to see from AIA in terms of capital instruments going forward? Will you be a regular visitor to euros?

Farbman, AIA: Perhaps it’s helpful if I answer that in the context of our key goals for the transaction. One was to reach an efficient and good pricing outcome, which we arrived at, as we just discussed. The other thing was to make sure that we brought in new investors and established our credit in the euro market, so that we would have the ability to come back to this market in the future, and I think the quality and the size of the book indicated that we were successful with respect to that goal, as well. So, yes, the intention is for us — alongside the various dollar markets that we access — to be able to consider the euro market for future issuance. This may be for a range of different structures — the bank-style Tier 2 that we issued, but it can also be hybrid debt going forward. Indeed, an important aim we had was to issue a bond that would be relevant for some time as a reference point, so that we can more easily return to the euro market quickly or when the opportunity arises in the future.

BIHC: What are the prospects for Tier 1 Limited issuance, as permitted under the HK GWS framework?

Farbman, AIA: Under the Hong Kong rules, Tier 1 Limited could make up 10% of our minimum required capital (which has to be met entirely by Tier 1), so it’s something that is available. However, given our levels of solvency capital, and the way that we manage our various businesses, we are pretty strongly capitalised from a Tier 1 perspective. So our expectation would be to focus more on the various types of Tier 2, because that’s the lower cost form of debt capital. But if there were opportunities in the future where Tier 1 Limited was competitive or compelling relative to the cost of Tier 2, it’s certainly something we could consider.

BIHC: Is there anything else you would like to highlight about your overall strategy in this area?

Farbman, AIA: It’s worth emphasising that AIA is a profitable growth company. While debt can be used for regulatory and ratings capital and capital structure optimisation,  the primary driver behind our debt issuance has been to fund strategic growth — through bancassurance agreements, acquisitions, and so on — and that’s how we would expect to continue to fund a portion of our growth in the future. This approach drives the slightly different composition of our issuance. We can look at senior debt, we can look at bank-style Tier 2, and we can look at hybrids — but it doesn’t all have to be one or the other, because we are not in a position where we’re entirely solving for regulatory or ratings outcomes.

Main image: AIA on the Bund, Shanghai; Credit: AIA

Why did you choose to go ahead with this €500m inaugural green Tier 2 transaction at this time?

We have a limited need for Tier 2 in 2021, €300m-€400m depending on business development this year. Our plan was therefore rather to issue the Tier 2 in the second half of the year, but we felt that — considering spreads and the level of demand — the market was just right for going ahead now, so we changed our plan and brought it forward a little.

We also did it sooner rather than later because we were concerned about there being more volatility in the second half of the year. The first half of the year has been something of an issuer’s market, partly due to there having been less supply, and our understanding is that more issuance can be expected in the second half of the year. Fears around inflation have already led to some rates volatility.

According to our breakeven analysis, spreads only have to widen 10bp-12bp before we make a saving by issuing now and taking a bit of negative carry for six to nine months. So we felt it was best to issue at these historically low spreads, rather than risk issuing later at a spread that could well be more than 12bp wider.

What determined the choice of the 12 non-call seven maturity?

We always like to do things a little differently to others. In the weeks preceding our issue, banks had been trending towards the shorter, 10 non-call five format due to the volatility in the market, with investors wanting to shorten duration. But when we approached the market, we felt that market sentiment was more positive, while the steepness between five and seven years was 16bp on the day. We therefore thought that we might attract better demand with a longer, 12 non-call seven issue, and our lead managers were neutral on this aspect. It turned out that investors were indeed quite positive on this.

You announced the transaction the day before launch — were there any particular messages you focused on in the premarketing?

We had a surprisingly high number of investors interested in calls. We had already done a lot of investor work on our Q1 numbers, but it turned out that investors still wanted to engage with us, particularly on the green aspect. Given that we do plenty of credit work with investors in between deals, we had also focused on the green aspect in the materials we had prepared, with a view to discussing this with investors. So we had a lot of calls in the afternoon after announcing the deal, and also investors coming back to us with questions during bookbuilding.

We are a small bank when compared against the big players, which is why we tend to take a 1.5 day approach to new issues and in general don’t favour intraday execution. This also takes into account the distinctive geographic distribution of our portfolio, taking in central and eastern Europe, as we need to give investors a bit more time to do their work and arrange or increase limits. Plus this time we also had the green aspect to discuss.

How did investors respond to the transaction?

We received an unusually large amount of positive feedback on the day we announced the trade, with concrete indications on spreads and order sizes. So when we entered the market on the day of launch, we already had quite a good feeling about the trade, but we were still quite surprised by the very positive dynamic that we had in the bookbuilding process — after 90 minutes, we were already above €1bn, which is exceptional for our name.

Did the pricing pan out in line with what you were targeting?

We were hoping to land at 170bp, but in the end our leads were convinced that 160bp was on the table because the order book was so strong, so we went ahead with pricing it at that level. We do not want to be greedy, but to leave a little room for performance, and the new issue has worked very well, tightening some 5bp afterward. I believe our name had been trading too wide in the secondary market beforehand, which further explains how we were able to price inside our initial expectations.

Did the less favourable market contribute to the choice of green for this Tier 2 trade?

We were convinced that the green flag would support the trade, although it is difficult to say now how much it affected the outcome.

We started issuing green bonds in 2018 and our first green bond matures the day after the value date of this new Tier 2. Our debut green bond was in senior format, but as we do not need senior funding at this point in time, it made sense to issue the next transaction, whatever the format, in green. In doing so, we have maintained our status as the biggest bank issuer of green bonds in Austria.

Katarzyna Kapeller, RBI

I would not issue an AT1 in green, but to me, issuing Tier 2 in green shows more of a commitment to sustainability because it’s longer dated — in this case, it shows a commitment of at least seven years. And as an issuer, I feel that the pricing benefit is higher in a higher beta product.

So the choice of green was both an economic and a strategic one.

What can you tell us about your funding plan for the year and how it is going?

As indicated earlier, we are done with Tier 2 for this year. On senior non-preferred, we do not have any plans for this year, at least, because as a multiple-points-of-entry group, in the Austrian resolution group we are quite comfortable with the subordination requirement. Senior preferred might be a topic for this year, depending on business development and other factors. Currently business looks better than we anticipated at the beginning of the year, and depending on further development, we might be active in senior in private placements or even in bigger size.

Coming back to green, you’ve been issuing in that format for some time, and you mentioned that you discussed green with investors — are there any changes on the green side?

No. We still use the framework from 2018. Why? The first reason is that although the EU Taxonomy is nearly done, it is still not clear how people should implement it in their frameworks. Many issuers have therefore not yet updated their frameworks, and we also felt that we should wait to see how it is treated in the market.

Secondly, two years ago we implemented internally a social bond framework aimed at supporting social assets. It is not a formal framework, but we would like to combine it with the green one. So instead of making a small update to the green framework, we would rather combine green and social in a bigger update under an umbrella framework.

We have seen interesting green issuance from other RBI group members recently. How is that coordinated among you all?

We have a good and clear coordination and communication regarding the issuance calendar — who has plans to do what, when — with the neighbouring team in the Austrian head office that covers the network banks. In this case, the network banks had plans that were more fixed and had reserved issuance windows, whereas we stepped in rather opportunistically. The recent Romanian issue was in the domestic currency and placed in Romania, and these local bonds can be timed more independently as they do not affect the international issuance plans of other group members. But when it comes to the Czech or Slovak international bonds that were issued recently, then we are very closely coordinating our activities.

What factors determined the timing of this €500m inaugural green Tier 2 transaction?

Our capital ratio is sound and well above regulatory buffers, and we also significantly exceed our MREL requirement, so we could afford to wait for the right moment to issue.

In fact, the main driver for the transaction was not regulatory, but related to Moody’s proposed adjustments to its Loss Given Failure (LGF) methodology, according to which the level of subordinated debt needed to shift the notching uplift in the matrix will be lowered. This new proposal allows us to optimise the benefits of the notching uplift within Moody’s matrix by calibrating the issuance of non preferred-senior and Tier 2.

As we were not in any hurry to issue, we prepared the transaction diligently and waited for favourable market conditions: Our impression was that a window before the summer break was feasible, and indeed the timing for the transaction was perfect.

Was there any particular reason for choosing the 10.25 non-call 5.25 structure?

From an issuer’s perspective, callable Tier 2 has some regulatory advantages versus plain vanilla subordinated debt. According to Article 64 of the CRR, the amount of Tier 2 must be amortised during the last five years prior to maturity. A call structure allows the issuer to optimise the regulatory recognition of regulatory capital, because there is no amortisation until the call date. In my opinion, investors have understood this regulatory background and recognise this kind of structure. Based upon this, I expect more and more issuers to come to market with callable structures for Tier 2 issuances in future.

Have there been any particular messages or themes you have focused on in your investor work lately, regarding BayernLB’s corporate strategy, sustainability strategy or anything else?

Our bank’s successful subordinated deal is the result of our many and varied efforts in the field of sustainable banking within the BayernLB group. Back in January 2021, we started marketing our sustainable finance framework, we then launched our green commercial paper programme — as one of the first such issuers in Europe — and other green and social bonds from the group followed.

The green subordinated bond rounds off our range of sustainable debt instruments, and makes the BayernLB group — BayernLB, BayernLabo and Deutsche Kreditbank (DKB) — one of the most active issuers in the sustainable segment in 2021.

How do you feel the transaction went? How do the pricing and distribution compare with your expectations?

The transaction was very well received by investors and represents several landmarks for BayernLB: the first public benchmark Tier 2 from BayernLB; the first euro green Tier 2 from a German bank; and the tightest re-offer spread for a euro Tier 2 benchmark in Germany. We were very pleased to see such a positive response from investors, and of course the final pricing was an excellent result for the bank.

Markets have been a little uncertain lately. Did this play into your decision to issue in green and/or the outcome?

From the very beginning, it was clear for us that if we were going to issue a benchmark this will be in green format. The quality of the assets of our green finance framework is excellent and we have realised that investors’ appetite for this kind of product is extremely high. By issuing a bond in green format, you reach a broader investor base, which helps both the issuer in the primary market, but also the investors in secondary market performance.

How does this Tier 2 issue fit into your funding plan and capital stack?

This transaction represents our third outing to the public debt markets this year, following our €500m green senior non-preferred issuance in February and our €500m covered bond in April. Our intention with those transactions is to diversify our investor base and promote our sustainable financing framework.

The subordinated green bond that we issued recently enables us to further increase our financial and regulatory flexibility, whilst optimising our cost of capital and strengthening our regulatory capital position. The main driver for the transaction was nevertheless to optimise Moody’s LGF analysis, as mentioned earlier.

What can you tell us about your funding plan for the year and how it is going?

We are almost done for this year, but are still open to private placements, although our approach to these is quite opportunistic in term of funding costs.

So far you have issued green bonds off your sustainable financing framework, with renewable energy as use of proceeds. What plans do you have for other asset categories and/or social bond issuance?

We are working on our portfolio and have already identified many new assets. I can imagine that in the future we will add transportation and real estate.

Are there any other aspects of the transaction or your strategy that you would like to highlight?

I really appreciated working with the joint leads. They were very focused and motivated, and this definitely contributed to the success of the this strategic transaction.

In terms of timing, if you are considering issuing capital, you should always do it when the market is favourable — not when you need it.

Bank+Insurance Hybrid Capital (BIHC): What were your AT1 needs and why did you come to the market with your debut at this time?

Giorgio Erasmi, UBI Banca: Our RWAs are a little less than €60bn, so with the current allowance to use AT1 for 1.5% of RWAs, our total capacity is close to €900m. We decided for our first issue to use almost half of this bucket.

We have been working on this AT1 project since the first half of 2018, but unfortunately in the last 18 months we were not able to find an interesting market that could provide us with pricing at a coupon level commensurate with our conservative approach. That’s why we decided to go to the market when at the beginning of this month we saw that there was a window of opportunity to issue at a coupon that, in our view, was in the area of 6% plus or minus a certain tolerance.

BIHC: How would you explain the state of the market so far this year?

Erasmi, UBI: Firstly, at the beginning of the year asset managers need to invest their money efficiently where possible – they don’t want to wait until later in the year.

Secondly, we are facing an environment where interest rates remain subdued and there is no sign of that changing in the near term. So there is no reason for investors to wait for better opportunities, but even more incentive for them to invest now.

Thirdly, the average coupon of new issues is very low if you remain in core countries – coupons range between a negative or zero rate and, for riskier assets, 2% or 3%. To get above 4% or 5%, you need to switch to other types of risk – we issued at a level of 5.875%. Our issue therefore proved an interesting proposition for investors – obviously AT1 is a riskier instrument, but it proved an attractive level for investors on a name that we believe they perceive as a good credit.

BIHC: How did the pricing compare with your expectations?

Erasmi, UBI: Honestly, we achieved a level very close to fair value based on our observations in the period preceding the new issue. We monitored fair value based on a comparison with UniCredit’s curve, which is a very liquid curve and comparable in terms of instrument. We saw fair value in the area of a final coupon of 580bp and we ended up at 5.875%, so in line with fair value, which is always a good result.

Indeed, post-deal, it appears that we may well have been too conservative in the calculation of the fair value, because our AT1 is stabilising at a differential to UniCredit’s well below what we calculated. It is trading at a pick-up of roughly 50bp to UniCredit AT1, which is a strong result. So we are happy with the level at which we issued, but even happier about the secondary market performance.

BIHC: I imagine the level of demand helped you achieve that result – did it surprise you, the size of the order book and number of investors who were involved?

Erasmi, UBI: Requests for bonds from 450 investors represents the widest demand we have seen on any issue in the 13 year history of our group since 2007. So yes, we were indeed surprised. We were aware that we were issuing an interesting instrument that would prove attractive for investors and that demand would probably be high, but we were not imagining such a high number. And furthermore the diversification from a geographical perspective was very interesting.

BIHC: You included a six month par call feature in your issue – what is your view on this relatively recent development in bank AT1?

Erasmi, UBI: Under this option, we have the ability to call the AT1 every day from January to June 2025, subject to 15 days’ prior announcement to investors on Euroclear. This is a good feature for the issuer, in that if and when we were to substitute the issue in 2025, we would reduce the period of double-counting in terms of coupon being paid, because as soon as we were to issue a new AT1, we would call the existing one.

BIHC: You mentioned this issue is equivalent to roughly half your AT1 bucket – so investors can expect to see another AT1 from you at some point? I note that you were also quite active last year across a range of instruments.

Erasmi, UBI: In the current funding plan we are executing in this first part of the year, we had only this issue, so in the short term we are not planning to sell another AT1. UBI Banca will announce the new business plan on 17 February, where more colour on future issuance plans for different instruments will be provided.

BIHC: Will your needs change in light of CRD Article 104 allowing AT1 and Tier 2 to partially fill P2R instead of CET1?

Erasmi, UBI: This is something to be monitored and acted upon in the future, if it is possible to do so.

For the time being, we have been communicating to investors that we see 12% as an appropriate level of CET1 for a bank with the business model of UBI Banca – a typical commercial bank with low risk profile, well diversified, focused on SME customers. Our view is that this is a stable and good level of CET1.

Read our previous Q&A with UBI Banca’s Erasmi on last year’s activity here.

Bank+Insurance Hybrid Capital: What is CNP Assurances’ motivation for issuing green bonds? How does it fit in with the company’s overall sustainability strategy and commitments?

Jean-Philippe Médecin, director for funding and own assets management, CNP: CNP Assurances Group has applied an ESG strategy in its asset management activity since 2006, when specific criteria were implemented for the equity portfolio. In 2011, we committed ourselves to respecting the UN Principles for Responsible Investment. In 2015, a global climate strategy was established. Finally, in 2018 then again in 2019, we committed to make €5bn in green investments from 2018 to 2021, an objective that has already been reached.

These initiatives, on top of others which we won’t go into here, show our strong commitment in favour of the energy and environmental transition. It therefore seemed completely natural to us to complete this policy with an innovation in our financial policy, with the launch of our inaugural green bond transaction.

BIHC: What are the use of proceeds of the transaction?

Stéphane Trarieux, head of funding, CNP: The use of proceeds are described in our framework published in June (which was the first in Europe released by an European insurance company). The net proceeds will exclusively finance or refinance, in full or in part, assets falling under three eligible green assets categories: high energy-performance buildings (new builds and renovations); sustainably-managed forests; and green infrastructure, such as renewable energy projects and means of transport with low CO2 emissions. Those assets are intended to contribute to three main environmental objectives: climate change mitigation, biodiversity protection, and pollution prevention.

BIHC: Your first green bond had been expected somewhat earlier — can you explain how the timetable evolved?

Médecin, CNP (pictured below): 2019 has been an active year for CNP Assurances, with several corporate events. As you know, we are in the process of welcoming a new controlling shareholder, La Banque Postale. Moreover, we signed in September 2019 a new agreement with our banking partner in Brazil, Caixa Econômica Federal. As a responsible issuer, we did not want to launch a new transaction before market participants have received comprehensive information about these developments. Finally, we considered that it was more responsible to issue after our Q3 results releases, in the context of the sharp decrease in interest rates that occurred this summer.

BIHC: There have been some questions over the applicability of the green bond concept to both insurance companies’ business models and also to capital instruments — what are your thoughts on this?

Trarieux, CNP: Insurance companies like CNP Assurances can choose to be socially responsible investors. We think we can demonstrate a strong influence on society and the natural environment through our investment policy, given the size of our portfolio (€279bn of assets under management integrating ESG criteria). Having said that, it is true that issuing green capital is quite innovative. Being the first European insurance company to publish a green bond framework, we took the view that having a subordinated bond as a host instrument was not an issue in relation to the Green Bonds Principles, and that there was no difficulty to be faced with our supervisor. On this specific point, it is worth mentioning that the use of proceeds language does not contradict the objective of obtaining the regulatory capital treatment. The instrument is compliant with Solvency II requirements for eligible own funds.

BIHC: What were the key messages you wanted to convey to investors during premarketing? How did they respond and did they focus, either positively or negatively, on any particular aspects?

Médecin, CNP: Firstly, we wanted to convince investors of the strength of our longstanding green commitment (since 2006 regarding the equity portfolio). Secondly, we wanted to detail our green investment strategy by highlighting concrete projects to the extent they could be found in the framework. We received enthusiastic feedback from investors, with some astonishment regarding the forestry investments. The investors were not all aware that CNP Assurances is the biggest private owner of forests in France. Forests are attractive because they strengthen CO2 capture, while delivering a proper long term yield. Regarding real estate, we have shown how new builds and renovations constitute an economic activity that contributes fully to the transition towards a decarbonised economy.

BIHC: What determined the choice of the 30 non-call 10 Tier 2 euro benchmark at this time?

Trarieux, CNP (pictured below): We have explained to the market and to the rating agencies that we intend to manage dynamically our portfolio of debt instruments, optimizing the fixed charges and rating agency requirements. That is why for each issuance we retain the flexibility whether or not to opt for the 30 non-call 10 format, which is more expensive, but implies better treatment with our two rating agencies. We also felt it was good timing for this transaction, with almost €3bn of debt coming to its first call date or maturity between 2020 and 2022.

BIHC: How do you feel about the outcome of the transaction?

Médecin, CNP: We are very satisfied with this transaction, which opens a new financing market for us at a very reasonable cost. The 2% coupon is the lowest ever for CNP Assurances for Tier 2 capital. Moreover, it is a nice showcase for our responsible investment policy.

BIHC: How, if at all, did the green aspect affect distribution and pricing?

Trarieux, CNP: We appreciate that the vast majority of investors in this transaction are ESG-driven. Hence, we consider that we obtained welcome investor diversification, including pure green funds.

Overall, we consider there is a small green premium that allowed us to price slightly inside the fair value of a similar non-green instrument.

BIHC: What are your plans for green bond issuance going forward?

Médecin, CNP: We think this market will develop, and we will of course be part of it. On the other hand, some clarification is expected from European authorities, in order to normalize standards.

BIHC: Is there anything else about your green strategy or the deal that you would like to highlight?

Trarieux, CNP: It has been a great experience for the funding team, bringing together our CSR colleagues and the real estate and infrastructure investment specialists. As you can imagine, we usually have the same type of recurring questions during our roadshows; this time, it was very different, with exciting discussions and very pertinent questions asked by the green investor community.

Bank+Insurance Hybrid Capital: What were your increased issuance needs in light of the APRA announcement and how have you planned to meet these?

Simon Reid, ANZ: The TLAC requirement entails an additional A$12bn (€7.4bn, US$8.1bn) of Tier 2 for ANZ, implying a required portfolio increase from A$8.5bn at 30 September 2019 to A$21bn by January 2024. That’s equivalent to A$4bn per year, which we expect to achieve in a broadly linear fashion, although we’ll have a bias towards being marginally ahead of that run rate. Clearly there is a significant cost of carry, but this is a higher risk product and we are aware that there will be times throughout the build-up of this capital that Tier 2 markets won’t be available to us.

BIHC: You moved quite quickly, on 19 July, with the first domestic Tier 2 after APRA’s announcement. Why did you decide to kick off your issuance thus?

Reid, ANZ: We think the domestic market is going to play a really important role in providing us with this capital and that its capacity for subordinated debt investment is likely to increase, both because of our increased requirement and because of the dynamics that are developing in Australia, which most of the rest of the world is very familiar with, particularly the low rate environment.

The 10 non-call five tenor/call combination made sense for us since we had room in that maturity bucket — which essentially you either use then or lose the ability to do so — and particularly at that point in time 10NC5 was the best available Tier 2 trade in Australian dollars. We also had some really constructive feedback from a number of Australian investors that gave us a great deal of confidence to approach such a trade. In spite of the Australian banks’ large Tier 2 issuance requirements, and the fact that meant we would be regular issuers over a fairly long period of time, investors came to us and said that they wanted to buy the paper now, and that was really helpful.

BIHC: Were the pricing and volume in line with your expectations?

Reid, ANZ: The transaction overall surprised us to the upside, but the size of the order book in particular and the size that we were able to raise really surprised us. We discussed at great length the appropriate size for the deal — obviously it was significantly larger than the previous largest deal in the Australian market, and we knew that we had to be really responsible with the first trade since the APRA announcement. But at A$3.6bn the order book was of such size and quality that we felt comfortable doing that size, and on balance we felt we needed to do A$1.75bn in order to have sufficient bonds to sell to investors who really wanted them.

BIHC: On 15 November, you issued a €1bn Tier 2 SDG bond, when any ESG-related subordinated issuance has been rare. What was the thinking behind going ahead with such a transaction?

Reid, ANZ: The SDGs generally are very important to ANZ and we’ve recently announced our commitment to a new A$50bn 2025 sustainability target aligned to the SDGs, which replaces a A$15bn low carbon target that we have met and exceeded. It’s significant that we’ve gone from a low carbon target to a broader SDG target.

So the SDG bond framework is very consistent with the broader goals of the bank and we were the first bank to issue an SDG bond in euros, in February 2018. This was really well received and we were in a position where we wanted to do another SDG-linked bond. We feel that Europe is the centre of excellence for ESG matters — for the time being we still receive far better engagement when discussing ESG in general with European investors than we do in other markets, notably the US, which is our other most significant offshore debt capital market.

We obviously have a significantly increased Tier 2 requirement, which reduces our senior and covered bond requirement basically one-for-one. In addition, balance sheet dynamics including a modestly reduced requirement for funding and a preference for shorter dated, three to five year senior and/or covered funding means that opportunities to issue in euros in senior or covered format are likely to be challenging in the near term, particularly due to the low rate environment.

For these reasons, it made sense for us to proceed with a Tier 2 SDG-linked bond. And during the roadshow our discussions with investors regarding the SDG framework and ANZ’s broader approach to sustainability were largely really positive and encouraging.

BIHC: Why did you choose the 10 non-call five maturity for the euro, like your domestic issue?

Reid, ANZ: We will broadly have a preference for shorter-dated callable subordinated debt, due to the lower cost and the efficiency of the call feature, avoiding the amortisation of our capital. We were, however, open to other tenors, in particular a 10 year bullet. We recognised the importance of this trade being a success and we weren’t going to try to sell bonds to investors that they didn’t want to buy, so there was an active discussion through our roadshow with investors as to their preference between 10 non-call five and a 10 year bullet. To be honest, going into those meetings I thought we would more consistently hear a preference for a 10 year bullet. However, while it was broadly balanced, I would say there was a general preference for a 10 non-call five. Obviously we didn’t meet with all investors, and some investors, particularly insurance companies, have a clear preference for longer dated bullet debt. But generally the feedback for a 10NC5 was favourable, and the transaction we ultimately executed demonstrated that.

BIHC: To what extent do you feel the SDG element affected the execution and outcome, whether that be in demand, pricing or any other aspect?

Reid, ANZ: It’s difficult to say. This was obviously a significant transaction for a number of reasons: there is the SDG angle, but it was also the first Australian bank Tier 2 issue in euros since the APRA announcement, and it was our first euro Tier 2 deal for 10 years. So while we were really pleased with the trade and most particularly the investor response, trying to determine what impact the SDG framework had on demand is hard to say — it certainly helped, but on our senior unsecured SDG trade its influence on the size and composition of the book was a little clearer.

BIHC: You mentioned the broad A$4bn per year Tier 2 issuance target earlier. Where do you currently stand and how do you see issuance developing?

Reid, ANZ: We’ve raised about A$3.3bn so far, and are targeting a further A$2.5bn-equivalent of Tier 2 debt by next September.

I’d consider what we’ve done as a really positive start. There has been good support for Australian bank Tier 2 since the APRA announcement, despite what you might call a supply overhang. I believe the volume of the requirement has in some markets — particularly in euros — helped, because it means that Australian major banks as a group will be regular issuers of subordinated debt and that makes us more relevant to investors. We are very fortunate that this announcement has taken place at a time when there is historically high demand for subordinated debt and riskier higher-yielding assets more generally. We are very pleased with the initial response to Australian bank Tier 2 across US dollars, Australian dollars and euros, and we think there’s really good opportunities to issue in a range of other currencies, including Japanese yen, Great British pounds and others. But we are also aware that this will not be the case consistently over the four year period in which we need to build up this Tier 2 capital, so we do need to be proactive and try to develop as broad an investor base as possible, and that is one of the key reasons that we chose to issue in euros.

BIHC: How do you envisage your SDG issuance going forward?

Reid, ANZ: It is something that we would like to continue to issue, but the frequency will be dependent on both balance sheet dynamics and the activities that constitute the A$50bn sustainability target. That amount includes lending but also facilitation of sustainable financing, for example, taking our customers to the debt capital markets to raise sustainable finance. So it’s hard to say how frequently we will be an issuer in SDG or when our next trade will be, but we do expect to be back in this format.