The divergence between European equity and bank debt is expected to broaden further in the coming months as fundamental changes in banking regulations continue to impact the industry, giving credit investors a lucrative relative value play.
The iTraxx Senior Financials index – the credit default swap benchmark for senior European bank debt – is currently outperforming the equivalent basket of underlying equities by a “significant” 42bp, credit strategists at Barclays said in a recent report. In contrast, European non-financial CDS are only 6bp better off than their equity counterparts.
The strategists pointed to the “fundamental changes” in banking regulation to explain the shift in market sentiment, after the Euro Stoxx Banks index dipped to just above 140 on July 10 – its lowest level since early January.
“Bank capital is now safer (and implicitly more attractive), but the resulting lower profits for financials lead to underperformance in their equities,” they said. “Credit outperforming equity for financials could be a lasting theme.”
Bank shares and bonds moved more or less in lockstep over the first quarter of the year (see chart above). Investors bought bank stocks as a leveraged way to play the European recovery, helping to fund a splurge of capital raisings from lenders in Italy, Spain, Portugal and Greece.
And though recent news about accounting irregularities at Portugal’s Banco Espirito Santo has compounded matters, financial shares were already struggling to maintain the momentum that carried the Euro Stoxx Banks index to a three-year high of 163 in early April.
That was the time when the positive correlation with bank debt began to fray. As bank equities sputtered, the Senior Financials index continued its rally, eventually reaching a multi-year low of 58bp in June – 25bp tighter than when the Euro Stoxx Bank index recorded its April peak.
“There has been a slow decoupling between bank equities and credit,» said one credit hedge fund manager. «Regulators are asking banks to hold higher equity buffers, which makes senior and subordinated bonds safer.”
Many believe current market conditions favour bonds over equities, not least because the European Central Bank’s continuation of easy monetary policy is expected to further support European credit.
JP Morgan analysts believe the iTraxx Main index, the bellwether for investment-grade credit, could grind in as far as 40bp from its current level of around 60bp – and investors appear to be bullish. Barclays said there is a US$17.2bn long position in the on-the-run Main index based on DTCC data, which they predicted should not fluctuate too much over the quiet summer months.
Furthermore, financial bonds have performed particularly strongly, buoyed by negative net issuance year-to-date in European senior bank debt. There has also been rampant demand for Additional Tier 1 securities despite solid supply of 11bn in the first half of the year, according to Citigroup, with average spreads falling by 134bp.
The outlook for bank equities, however, has been less rosy. While few expect the problems at BES to be replicated elsewhere, many lenders in the region still have to plug capital shortfalls, incentivising them to retain more earnings rather than distribute cash to shareholders.
And on top of pressure from the ECB to shore up Core Tier 1 ratios, the seemingly never-ending series of eyewatering fines being handed down by US regulators is plaguing European banking names. BNP Paribas’s recent US$8.9bn fine is the highest on record.
When combined with the outlook of anaemic economic growth across the eurozone, many expect the bank equity and credit decoupling trade to have some legs in it yet.
“The situation is not all that dissimilar to the Japanese scenario,” said the hedge fund manager. “Credit keeps on tightening as rates fall and defaults remain low, while flat regional growth is bad for equities.” [Reuters]