Monthly Commentaries

March 2024

Economic and investment highlights

Global Credit Strategy

How we did in March: The fund returned between 1.43% and 1.13% across different share classes, compared to EUR HY (BAML HE00 Index) 0.4%, US HY (BAML H0A0 Index) 1.2% and EM sovereign credit (BAML EMGB Index) 1.8%. Performance in March, gross of fees in EUR, was: (i) Credit: 1.56%, with 1.95% from cash bonds and -39bps from CDS; (ii) Rates: -9bps; (iii) FX: -6bps, (iv) Equity: 3bps and (v) Other: 0bps.

What we are doing now: March was a strong month for risk assets. Credit benefited as spreads tightened in a context of stable rates.

Our Fund performed positively over the month, thanks to broad credit exposure and alpha generation in specific single names. Hedges on credit indexes subtracted from performance.

Overall, we currently find little value in credit spreads, with tight valuations making the market vulnerable to both the emergence of individual credit risk and a potential resurge of global activity data.

We run risk on the cautious side vs the past two-year range. Our net credit exposure is c.50%, duration is 3.1y, and longs focus on front-end bonds or names with a catalyst. As we highlight in our recent Algebris Bullet, we think markets are still priced for very high chances of soft landing, opening up to some risk of disappointment.

More in detail:

  • The Fund blended YTC is 7.4%, with average rating BBB-.
  • The Fund duration is now 3.1y, substantially lower than in late October. We see central bank pricing for 2024 appropriate but hold steepeners given strength in US data.
  • Our net credit exposure is 51%. We have some 8% in cash currently, and hold protection via US IG and HY spreads, European HY spreads and EM spreads.
  • Net exposure in financials (incl. cash short and single name CDS) represents 34% of the book. AT1 and financial subordinated was a key trade in 2023, and some of the bonds re-priced 25% since March. The asset class outperformed since October. We remain constructive but reduce some of the winners.
  • Net corporates exposure (incl. cash short and single name CDS) represents 33% of the book. We focus on 8-10% yielding bonds backed by a solid pool of hard assets, at valuations that heavily discount the underlying value, or with imminent refinancing events. European real estate hybrids were a strong theme contributing to our performance in the first quarter.
  • Net EM exposure (incl. cash short and single name CDS) represents 17% of the book. In the first quarter, we moved our focus from local to hard currency, with a focus on high yield countries. In local we still like Brazil and Mexico.

Financial Credit Strategy

The positive tone across risk assets carried over into March as Central Banks globally indicated that the inflation fight had largely been won and the debate turned to when the first rate cuts would take place. Although there is still a large degree of uncertainty around the timing and eventual magnitude of these cuts, the market for now has seemingly taken comfort from the fact that rate hikes should no longer be necessary. Worst case, it is very much a question of higher for how much longer and importantly this does vary significantly across regions with United States on a different (stronger) economic path than Europe and the UK.

In March, equity indices across Europe rallied on average a further c5%, boosting YTD performance to c10%, whereas in the US it was a more subdued c2%, taking YTD to c8%. European bank equity indices added c13% in March for a YTD total return of c17%, compared with c9% and c10% respectively for US banks as regional banks continue to drag performance (-3% YTD). Across credit in March, higher quality and yielding assets outperformed with AT1 spreads c50bps tighter (+2pts), more than twice the move of financial Senior spreads (c20bps).

European banks wrapped up their robust 4Q / FY23 results season with few blemishes and we expect an ongoing continuation of solid fundamental operating trends throughout FY24. First quarter results should confirm these from the second half of April onwards and in the meantime rating agencies are still playing catch up via ongoing upgrades to the smaller domestic issuers across Italy and Spain.

M&A took centre stage across the UK financial landscape in March. Whilst Ageas’ pursuit for the UK Motor insurer, Direct Line, ultimately failed due to pricing discipline by the bidder, the takeout offer made by Nationwide to purchase Virgin Money was far more successful. Without compromising its solvency, this transaction enables Nationwide to make use of its excess capital to bolster its position across mortgages and consumer unsecured credit and diversify its funding base with access to corporate deposits. Nationwide intends to integrate Virgin Money over a period of 6 years. Although this instance of M&A could be seen as one-off due to Nationwide’s idiosyncratic position, it nonetheless raises hopes of further consolidation across the European banking landscape.

Primary issuance picked up significantly in March with over EUR60bn printed across the entire capital structure of leading European banks, making it the fifth most active month in the last 6 years. Year-to-date issuance of just under EUR200bn is on par with last year’s activity and we believe reflects potential geopolitical uncertainties heading into the final quarter of the year.

We expect primary momentum to remain healthy in the second quarter this year as issuers seek to complete their funding plans in a shorter time span. Interestingly, issuance of capital instruments in 1Q24 was c25% higher than the equivalent quarter last year, driven essentially by dated subordinated securities. AT1 refinancings are already more than 50% completed and we expect issuers to continue making use of early tenders ahead of call dates.

Financial Equity Strategy

A very long and drawn-out FY23 earnings season has finally come to an end, with the European insurers rounding up the rear with the central theme of capital repatriation. We saw the large mid-caps like AXA and Allianz lift their ordinary payout ratios to a minimum of 60% (from 50% previously) while three of the four names announced new buybacks. Yet, their operational performance remained far less convincing as all four multi-line insurers reported weaker underwriting results heavily impacted by the higher incidences of nat cat events such as the floods in Europe in the first half of 2023.

In contrast, our positioning in the Lloyd’s of London insurers was rewarded as this niche group were the outright winners from the results season with stellar operational results – undiscounted combined ratios in the low-80s against the median mid-90s for the large caps. Such strong underwriting earnings allowed the peer group to surprise with capital returns. Hiscox launched an unexpected $150mn buyback, Beazley surprised positively with its decision to undertake a $325mn buyback rather than special dividend after the pre-FY23 update in February and lastly, Lancashire announced another special dividend of $0.50 per share after a similar figure disclosed at the 3Q23 trading update. Similar to many banks in Europe, we see the potential for low/mid double digit total payout yields across this group. As the companies’ capital priorities shift from growth to shareholder returns as seen during the 2014-2018 period, we expect the current forward P/B valuation gap for this peer group to continue to narrow from c.1.3x against their 10-year average of 1.9x.

In the US, banks were generally flattish heading into the Federal Reserve meeting with some unease around the potential for hawkish commentary given recent firm inflation prints. However, Fed Chair Powell’s comments post the meeting were interpreted as dovish enough to keep rate cuts on the table within the next few months. This posture helped induce a broad rally in financials led by regional banks which are expected to benefit from lower short-term rates providing relief on funding costs. Moreover, the laggards in March included some of the best 2024 performers prior to the month, showing some rotation into beat-up names and increased risk-on investor appetite. While we have fairly modest exposure to the US bank space currently, we remain focused on finding banks with steeply positive net interest income and earnings trajectories in 2024 and 2025 where valuations are attractive, capital is strong, and credit risk is manageable. Additionally, merger activity could rebound strongly if the regulatory environment eases. US banks could well become much more interesting in the next 6-12 months – for now we remain largely on the sidelines.

Meanwhile, in European banks, we continue to believe there is plenty of runway to go for the sector, which has started the year strongly as fears of rate-related earnings downgrades proved unfounded. In fact, we have seen low/mid single digit earnings upgrades in Europe, which has led to the beginning of an unwind of the historically high valuation discount at which the sector has been trading in recent months. Even today, after a +25% move in 2023 and a +15% move in 1Q24, European banks sit near historical lows in terms of absolute P/E and relative valuations versus the market. Our thesis all along in this group has been that fundamentals will first drive earnings upgrades, to be followed by a gradual re-rating as the market comes to understand the resilience of earnings power. We have just started this process (sitting at 6.5x for the group vs historical average of 9-10x and the recent trough of 5.5x). With massive capital return on top, we see scope for significant total returns still to come.