How we did in August: The fund returned between -0.9% and -1.3% across different share classes, compared to EUR HY (BAML HE00 Index) -1.2%, US HY (BAML H0A0 Index) -2.4% and EM sovereign credit ( BAML EMGB Index) -1.0%. Performance in August, gross of fees in EUR, was from: (i) Credit: -252bp, with -212bp from cash and -40bp from CDS; (ii) Rates: 132bp; (iii) FX: 1bp; and (iv) Equity: 13bp and (v) Other: 0bp.
August was characterized by a repricing wider of global rates. Gas prices continued to rally in Europe and central banks delivered a hawkish message at Jackson Hole, reverting most July gains in rates. Credit spreads continued to tighten in the first half of the month, then started widening as market re-priced bigger economic disruption from energy shortages in Europe. Our performance was slightly hurt by the credit re-pricing but largely insulated from the move in rates thanks to extensive hedging.
What we are doing now: We maintain net credit investment above 80% as we see credit spreads very attractive on a 6-12 months horizon given the economic risk implicit in the price is now extreme, so that actual credit stress will be lower than priced in most scenarios. We have been slightly adding risk over the past few weeks, as rates widening hurt spreads too. We maintain rates duration below 2y to protect investors from rates volatility. We have marginally increased duration in August as US Treasury widened, but we keep rates duration more than 2y below spread duration, so that the fund is mostly long credit spreads. For more analysis and our full views on credit see our latest Algebris Bullet.
We deploy capital mostly in high grade / high quality bonds (both DM and EM). Our average credit rating is BB+, so we have similar amount invested but substantial less risk than the average HY or EM fund.
On the cash book, we focus longs on quality across all segments we are active in. In financials, we focus on US banks seniors and selected European AT1s. In corporate credit, we focus on quality credits with resilient cash flows, ample liquidity and manageable debt maturities. Main focus on Telecoms and Healthcare where additional tightening expected from consolidation and proactive refinancing. In emerging markets, we focus on countries with low refinancing needs in external debt markets and selected local markets close to the end of tightening cycles.
Our protection focuses on issuers which can’t sustain their leverage in an environment of weak growth and rising interest rates. In corporate credit, our focus is on unsustainable capital structures in over-levered retail, debt collectors and real estate issuers. In emerging markets, we focus on sovereigns with limited market access and high maturity walls.
Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and we position our portfolio accordingly.
Financial Credit Strategy
August was a tale of two halves for risk assets. The month started on a positive note with early signs of a peak in inflation boosting sentiment before pivoting to negative on the back of the hawkish Powell speech at Jackson Hole on the 26th. Prospects of faster and more aggressive rate hikes, combined with weakening macroeconomic data and new spikes in the cost of gas (+26% MoM), increased concerns around recession, pushing equities into negative territory across the US (-4.2%) and Europe (-5.1%). Despite outperforming the wider market on strong results and ongoing earnings upgrades, banks also closed the month down by -2.4%.
The pricing of further rate hikes caused a sharp negative move across rates. In Europe, where rates are now expected to rise above 1.8% by February 2023 to counter stubborn inflation prints, sovereigns lost c.5% with Gilts (-8.2%) one of the worst monthly performers. The sell-off in rates was a key driver of weakness in credit, with financials’ bonds down anywhere from c.2% in USD to c.6-7% in GBP but outperforming corporates. At current levels, we continue to believe that financial credit offers superior risk-return with new opportunities for 7-9% yields in 3-4year duration bonds from top quality, diversified issuers.
The main theme for financials in August was the announcement of Q2 results and primary issuance that followed the blackout period. Results were strong across the board, showing first tangible signs of the positive effect of higher interest rates on profitability and triggering further EPS upgrades. Around 80% of European banks beat consensus estimates on net interest income, which was up 4% on an aggregate basis. Fees and control over costs fuelled even higher beats of operating profit. For the time being, there are scant asset quality concerns and provisions came in lower than expected.
In this respect, we remain comfortable with the level of overlay provisions set aside during Covid and as well as with the existing government guarantees, which account for up to 30% of corporate loan books (e.g. Italy and Spain). Capital was the only marginal blemish (down c.10bps on average vs c.360bps excess) due essentially to the unwind of certain regulatory easing measures post-Covid and adjustments to assets (OCI), which may well reverse as market volatility normalises.
For insurers specifically, their Q2 results were widely positive with two distinct themes: weaker financial markets weighing heavily on their investment returns especially for Life insurers, and evidence of precautionary reserving in response to the inflationary environment in P&C. Capital positions of insurers also remained relatively robust, and in almost all cases, benefiting from the continued rise in interest rates (+6 pp to 220% on average).
Several banks across Europe started their buybacks in August, partly to compensate the 2020-21 dividend bans. Whilst these are capital detractors, unlike dividends they are diluted in time and therefore easier to adjust should the bank need to unexpectedly retain capital. Recent approvals, such as that granted to Unicredit’s second tranche of the 2021 buyback in late August, also confirm the regulator’s comfort in the solidity of the sector. All in all, we remain confident in the strength of fundamentals across the banking system, in particular of our higher quality names which should cope well in most economic scenarios.
Primary activity picked up significantly and amounted to twice the level issued last August. This was essentially driven by Senior Non Preferred which accounted for three-quarters of the total and at EUR35bn was the largest monthly amount ever registered by European banks. This helps explain the move wider in credit spreads given the seasonally less liquid month that is August, combined with 50bps+ moves in sovereign rates and ongoing geopolitical headlines. In terms of capital, issuers front-loaded some of their refinancing needs with over EUR5bn of AT1s announced and a similar amount expected for September, after which we expect issuance to die down. This technical nuance between Senior and AT1s from a net issuance perspective should continue to buoy sentiment in the latter’s favour.
Financial Equity Strategy
August was yet another historic month for bond yields, with a dramatic back up in rates across developed markets. Importantly – and positively – for banks, much of this bond market selloff is happening at the front end of the curve, with policy rate expectations moving significantly higher. Just since the end of July, an additional three hikes have been priced in to the 1Y forward Fed curve, while expectations for the BOE and the ECB have gone up to six and eight full hikes respectively. This is music to the ears of US, European, and UK banks. Free money in the form of rising deposit spreads has been in short supply for years, and now it is pouring in. For context, in their NII guides, most UK banks are projecting the BOE to have rates around 2.25%; the forward market is currently pricing in closer to 4.5%! When sitting on £250 bn of excess deposits, as UK banks are, that is a large amount of free money (nearly £6 billion worth) that is not currently in consensus numbers. A bank like NatWest in the UK, which made 9% ROTE in 2021, has already substantially increased its 2023 ROTE guidance up to 14-16% without the help of the most recent back up in rates. High teens ROTE is certainly becoming plausible, which looks completely out of step with its miserly valuation of <0.9x tangible book. Massive capital return (close to 50% of market cap in the next three years) is simply a cherry on top for this stock and many similar holdings in our portfolio.
But what about the elephant in the room, the recession that everyone has already predicted and positioned for? The most recent jobs numbers in the US certainly do not feel recessionary to us, nor do 50-year lows in unemployment in the UK and record low unemployment in the Eurozone. But clearly, there is a war and an energy crisis underway and we cannot simply dismiss the negative impacts. However, our point is that for banks in our portfolio, we expect the uplift from the step change higher in revenues (even before the most recent back up in hiking expectations) from rising rates to at least match, but in most cases significantly outweigh, the impact of the likely increase in cost of credit. Taking Deutsche Bank – in the thick of the gas crisis, and not a particularly rate-geared bank – as one example, their internal modeling implies a €1 bn rise in credit costs from a full shutoff of Russian gas pipelines. Before sneering about Deutsche Bank internal models, we should also consider the Covid level of provisioning in 2020 was €1.8 bn (in 2021 it was just €0.5 bn). So doubling the internal projection gets to slightly above the 2020 level, which seems a reasonably harsh stress scenario, especially considering Deutsche assumes zero fiscal aid from Germany – an assumption already made out of date by Germany’s €65 bn fiscal stimulus program just announced. €2 bn of stress credit losses compares to ~€7 bn of pre-provision earnings power before a €2-3 bn uplift from NII over the next several years. And there is not exactly a lot of optimism being priced into the shares anyway you look at it: the stock trades at 3.5x ’24 earnings assuming the forward curve, 4.5x if we strip out the rate benefit, and 5x if we strip out the rate benefit and double the cost of risk. The stock is even cheaper if we further adjust for its 80% holding in the asset manager DWS – but we think the point is made.
The market continues to be singularly focused on the potential negatives of war, recession, and the energy crisis. We are fully cognizant of the risks but the heavily fortified balance sheets, massive capital return, huge gearing to an ongoing backup in the bond market, and heavily distressed valuations make banks a highly compelling – and contrarian – value opportunity today.
Global Credit Strategy
How we did in August: The fund returned between -0.9% and -1.3% across different share classes, compared to EUR HY (BAML HE00 Index) -1.2%, US HY (BAML H0A0 Index) -2.4% and EM sovereign credit ( BAML EMGB Index) -1.0%. Performance in August, gross of fees in EUR, was from: (i) Credit: -252bp, with -212bp from cash and -40bp from CDS; (ii) Rates: 132bp; (iii) FX: 1bp; and (iv) Equity: 13bp and (v) Other: 0bp.
August was characterized by a repricing wider of global rates. Gas prices continued to rally in Europe and central banks delivered a hawkish message at Jackson Hole, reverting most July gains in rates. Credit spreads continued to tighten in the first half of the month, then started widening as market re-priced bigger economic disruption from energy shortages in Europe. Our performance was slightly hurt by the credit re-pricing but largely insulated from the move in rates thanks to extensive hedging.
What we are doing now: We maintain net credit investment above 80% as we see credit spreads very attractive on a 6-12 months horizon given the economic risk implicit in the price is now extreme, so that actual credit stress will be lower than priced in most scenarios. We have been slightly adding risk over the past few weeks, as rates widening hurt spreads too. We maintain rates duration below 2y to protect investors from rates volatility. We have marginally increased duration in August as US Treasury widened, but we keep rates duration more than 2y below spread duration, so that the fund is mostly long credit spreads. For more analysis and our full views on credit see our latest Algebris Bullet.
We deploy capital mostly in high grade / high quality bonds (both DM and EM). Our average credit rating is BB+, so we have similar amount invested but substantial less risk than the average HY or EM fund.
On the cash book, we focus longs on quality across all segments we are active in. In financials, we focus on US banks seniors and selected European AT1s. In corporate credit, we focus on quality credits with resilient cash flows, ample liquidity and manageable debt maturities. Main focus on Telecoms and Healthcare where additional tightening expected from consolidation and proactive refinancing. In emerging markets, we focus on countries with low refinancing needs in external debt markets and selected local markets close to the end of tightening cycles.
Our protection focuses on issuers which can’t sustain their leverage in an environment of weak growth and rising interest rates. In corporate credit, our focus is on unsustainable capital structures in over-levered retail, debt collectors and real estate issuers. In emerging markets, we focus on sovereigns with limited market access and high maturity walls.
Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and we position our portfolio accordingly.
Financial Credit Strategy
August was a tale of two halves for risk assets. The month started on a positive note with early signs of a peak in inflation boosting sentiment before pivoting to negative on the back of the hawkish Powell speech at Jackson Hole on the 26th. Prospects of faster and more aggressive rate hikes, combined with weakening macroeconomic data and new spikes in the cost of gas (+26% MoM), increased concerns around recession, pushing equities into negative territory across the US (-4.2%) and Europe (-5.1%). Despite outperforming the wider market on strong results and ongoing earnings upgrades, banks also closed the month down by -2.4%.
The pricing of further rate hikes caused a sharp negative move across rates. In Europe, where rates are now expected to rise above 1.8% by February 2023 to counter stubborn inflation prints, sovereigns lost c.5% with Gilts (-8.2%) one of the worst monthly performers. The sell-off in rates was a key driver of weakness in credit, with financials’ bonds down anywhere from c.2% in USD to c.6-7% in GBP but outperforming corporates. At current levels, we continue to believe that financial credit offers superior risk-return with new opportunities for 7-9% yields in 3-4year duration bonds from top quality, diversified issuers.
The main theme for financials in August was the announcement of Q2 results and primary issuance that followed the blackout period. Results were strong across the board, showing first tangible signs of the positive effect of higher interest rates on profitability and triggering further EPS upgrades. Around 80% of European banks beat consensus estimates on net interest income, which was up 4% on an aggregate basis. Fees and control over costs fuelled even higher beats of operating profit. For the time being, there are scant asset quality concerns and provisions came in lower than expected.
In this respect, we remain comfortable with the level of overlay provisions set aside during Covid and as well as with the existing government guarantees, which account for up to 30% of corporate loan books (e.g. Italy and Spain). Capital was the only marginal blemish (down c.10bps on average vs c.360bps excess) due essentially to the unwind of certain regulatory easing measures post-Covid and adjustments to assets (OCI), which may well reverse as market volatility normalises.
For insurers specifically, their Q2 results were widely positive with two distinct themes: weaker financial markets weighing heavily on their investment returns especially for Life insurers, and evidence of precautionary reserving in response to the inflationary environment in P&C. Capital positions of insurers also remained relatively robust, and in almost all cases, benefiting from the continued rise in interest rates (+6 pp to 220% on average).
Several banks across Europe started their buybacks in August, partly to compensate the 2020-21 dividend bans. Whilst these are capital detractors, unlike dividends they are diluted in time and therefore easier to adjust should the bank need to unexpectedly retain capital. Recent approvals, such as that granted to Unicredit’s second tranche of the 2021 buyback in late August, also confirm the regulator’s comfort in the solidity of the sector. All in all, we remain confident in the strength of fundamentals across the banking system, in particular of our higher quality names which should cope well in most economic scenarios.
Primary activity picked up significantly and amounted to twice the level issued last August. This was essentially driven by Senior Non Preferred which accounted for three-quarters of the total and at EUR35bn was the largest monthly amount ever registered by European banks. This helps explain the move wider in credit spreads given the seasonally less liquid month that is August, combined with 50bps+ moves in sovereign rates and ongoing geopolitical headlines. In terms of capital, issuers front-loaded some of their refinancing needs with over EUR5bn of AT1s announced and a similar amount expected for September, after which we expect issuance to die down. This technical nuance between Senior and AT1s from a net issuance perspective should continue to buoy sentiment in the latter’s favour.
Financial Equity Strategy
August was yet another historic month for bond yields, with a dramatic back up in rates across developed markets. Importantly – and positively – for banks, much of this bond market selloff is happening at the front end of the curve, with policy rate expectations moving significantly higher. Just since the end of July, an additional three hikes have been priced in to the 1Y forward Fed curve, while expectations for the BOE and the ECB have gone up to six and eight full hikes respectively. This is music to the ears of US, European, and UK banks. Free money in the form of rising deposit spreads has been in short supply for years, and now it is pouring in. For context, in their NII guides, most UK banks are projecting the BOE to have rates around 2.25%; the forward market is currently pricing in closer to 4.5%! When sitting on £250 bn of excess deposits, as UK banks are, that is a large amount of free money (nearly £6 billion worth) that is not currently in consensus numbers. A bank like NatWest in the UK, which made 9% ROTE in 2021, has already substantially increased its 2023 ROTE guidance up to 14-16% without the help of the most recent back up in rates. High teens ROTE is certainly becoming plausible, which looks completely out of step with its miserly valuation of <0.9x tangible book. Massive capital return (close to 50% of market cap in the next three years) is simply a cherry on top for this stock and many similar holdings in our portfolio.
But what about the elephant in the room, the recession that everyone has already predicted and positioned for? The most recent jobs numbers in the US certainly do not feel recessionary to us, nor do 50-year lows in unemployment in the UK and record low unemployment in the Eurozone. But clearly, there is a war and an energy crisis underway and we cannot simply dismiss the negative impacts. However, our point is that for banks in our portfolio, we expect the uplift from the step change higher in revenues (even before the most recent back up in hiking expectations) from rising rates to at least match, but in most cases significantly outweigh, the impact of the likely increase in cost of credit. Taking Deutsche Bank – in the thick of the gas crisis, and not a particularly rate-geared bank – as one example, their internal modeling implies a €1 bn rise in credit costs from a full shutoff of Russian gas pipelines. Before sneering about Deutsche Bank internal models, we should also consider the Covid level of provisioning in 2020 was €1.8 bn (in 2021 it was just €0.5 bn). So doubling the internal projection gets to slightly above the 2020 level, which seems a reasonably harsh stress scenario, especially considering Deutsche assumes zero fiscal aid from Germany – an assumption already made out of date by Germany’s €65 bn fiscal stimulus program just announced. €2 bn of stress credit losses compares to ~€7 bn of pre-provision earnings power before a €2-3 bn uplift from NII over the next several years. And there is not exactly a lot of optimism being priced into the shares anyway you look at it: the stock trades at 3.5x ’24 earnings assuming the forward curve, 4.5x if we strip out the rate benefit, and 5x if we strip out the rate benefit and double the cost of risk. The stock is even cheaper if we further adjust for its 80% holding in the asset manager DWS – but we think the point is made.
The market continues to be singularly focused on the potential negatives of war, recession, and the energy crisis. We are fully cognizant of the risks but the heavily fortified balance sheets, massive capital return, huge gearing to an ongoing backup in the bond market, and heavily distressed valuations make banks a highly compelling – and contrarian – value opportunity today.