Strategy Spotlight
February 2015
European High-Yield Financials—A growing asset class
Subordinated bonds issued by financial sector companies, predominantly banks, are
likely to grow into a stand-alone high-yield bond asset class; investors who create a new
bucket for this nascent asset class are likely to be rewarded for their efforts.
Satish Pulle
Head of Financials & ABS,
Portfolio Manager, ECM
The growth of the high-yield financial sector makes a compelling case for a stand-alone
allocation. The table below illustrates the growth in high-yield financial bonds over
the last decade. As illustrated in the last two columns, this asset class has seen rapid
growth. This is in part due to market appetite for these securities but also due to the
number of ‘fallen angels’ (European bank bonds downgraded below investment grade).
Index
High Yield Ex.
Financials HNE0
Date
High Yield Inc.
Financials HNE0
High Yield
Financials
CoCo
All figures stated in €B face value
Jan-05
50.2
50.2
–
Jan-06
67.3
68.3
1.0
Jan-07
69.8
72.4
2.6
Jan-08
69.5
75.4
5.9
Jan-09
60.6
70.2
9.4
Jan-10
81.1
111.8
30.7
Jan-11
103.2
136.2
33.1
Jan-12
124.7
164.3
39.6
Jan-13
149.5
206.6
57.2
Jan-14
188.8
245.9
57.1
41
Jan-15
209.8
289.5
79.7
103
Sources: Bank of America Merrill Lynch, Bloomberg
High yield financial bonds included in the Merrill Lynch Euro Financial High Yield
Constrained Index (HEBC) have grown from just under €6B ($9B) in 2008 to €80B
($97B) in 2015. Yet these numbers present only part of the picture, as they exclude the
growth in recent years of Contingent Convertible (CoCo) bonds. To reflect the growing
universe, Merrill Lynch launched a CoCo index in January 2014, valuing these securities
at €41B ($56B). As of January 2015, the CoCo index values CoCo securities at €103B
($117B), taking the total high yield financials outstanding to €184B ($214B).
Banks issuance to drive sustained growth
Financial reforms stemming from the 2008 financial crisis have led to more robust banking regulations. European regulations now require banks to issue Additional Tier 1 (AT1)
bonds amounting to 1.5% of risk-weighted assets (RWAs) by 2019. These AT1 bonds are
typically rated high yield, as they contain features such as coupon cancellation and equity
conversion/write-off if certain triggers are breached. Considering a sample of the largest
30 banks in Europe, analysts estimate issuance needs of €100B – €150B to meet this
regulatory requirement over the next three to five years. These numbers could rise if
regulators decide to further increase risk weightings applied to loan and bond portfolios.
In addition, several national regulators require banks to maintain their leverage ratios at or
above 3% - 4% of Total Assets. This requirement can lead to increased AT1 bond issuance,
over and above the minimum level set at 1.5% of Risk Weighted Assets. Banks which face
higher AT1 issuance to meet leverage ratio requirements include Deutsche Bank, BNP, and
Barclays among others.
Furthermore, weak banks, especially those in peripheral
countries such as Portugal and Spain, are likely to need to
issue high-yield Tier 2 bonds. European bank Lower Tier 2
bonds (LT2) no longer benefit from any ratings uplift from
sovereign support given numerous recent examples where
subordinated bondholders have been “bailed in” whilst senior
bondholders have been left untouched (SNS, Hypo-Alpe
Adria, and Banco Espirito Santo).
We are also likely to see significant high-yield financials
issuance from emerging market banks in Europe and Asia,
as they capitalise on opportunities to grow balance sheet
assets. Emerging market banks from Russia, Turkey, and
India, to name just a few, can add meaningful amounts to
the high-yield financials issuance pipeline. As an example,
the Bank of America Merrill Lynch EEMEA Subordinated
Financials Index (EBEF), as at January 2015, is comprised of
33 bond issues with a face value of $18B. The EBEF index
has an average rating of BB2, and a high yield of 10.4%, partly
driven by Russian banks facing U.S. and European sanctions.
Based on the above broad brush analysis, we believe highyield financial bond issuance volumes are likely to be large
enough to make up a stand-alone sector of €250B – €300B
($285B – $340B) over the next five years.
AT1 issuance will help to keep spreads attractive
Recently finalised rating agency methodologies lead us to
believe that a large proportion of AT1 bonds are likely to be
rated below investment grade, and will remain so over the
next five years. The table below shows senior and AT1
ratings for several banks:
Issuer
Rabobank
HSBC
SEB
Nordea
Societe
Generale
Credit
Agricole
Nationwide
Senior Unsecured
Additional Tier 1
Ratings
CoCo Ratings
S&P Fitch Moody’s S&P Fitch Moody’s
A+
AAAa2
Baa3
A+
AAAa3
BBB
Baa3
A+
A+
A1
BBBAA- AAAa3
BBB
BBB
A
A
A2
A
A
A
A
A2
A2
BB
BB
BB
Ba2
BB+
BB+
Ba2
The rating examples above show that subordinated debt ratings
are already notched down from stand-alone ratings, in other
words, the agencies assume no support from governments.
We acknowledge and support these rating agency methodologies which result in low investment-grade to below investmentgrade ratings. Our own view is that over the next few years,
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the risk of a write-down or equity conversion remains low
for the majority of AT1 issuers for the following reasons:
 Compared to pre-crisis levels, most issuers have much
higher capital ratios and lower leverage.
 Most issuers have reduced risky asset portfolios such as
collateralised debt obligations, though peripheral banks still
have large non-performing loan portfolios to work through.
 All Eurozone issuers have substantial access to ECB liquidity
lines such as the main refinancing operations (MRO) and
targeted long-term refinancing operation (TLTRO).
 Central banks remain vigilant and keen to prevent systemic
risk episodes, as evidenced by the ECB’s QE programme;
discussion in the U.S. on financial stability risks of
prolonged zero interest-rate policy; and the bailout of
Banco Espirito Santo.
 Banks have become much more risk averse in their lending
as well as in their trading portfolios as shown by generally
moderating non-performing loans, and lower VaR measures.
Significant diversification
While at first sight the financials credit sub-sector may seem
to be narrowly defined, in reality, the sub-sector forms
around 50% of investment grade credit, and as was described
above, volumes in high yield financials are of a similar order of
magnitude to corporate high yield bonds. Additionally, we can
point to diversification amongst country, issuer and currency.
Country: Among banks that have already issued CoCos are
those from Switzerland, Germany, France, Spain, Italy, the
U.K., Belgium, and Denmark. In the future, we expect issuers from Scandinavian and Southern European countries to
join the issuer list.
Issuer: The Bank of America Merrill Lynch CoCo index
contains bonds from more than 20 issuers. We expect this
issuer count to rise to 50–75 in the next five years.
Issuer diversity in financials is lower than in the corporate
high-yield sector. Historically, we have observed higher
correlation within the financial sector with respect to
fundamentals and return performance. Given this, we feel
it is particularly important that strategies focusing on financials
adopt an absolute return approach, and aim to protect
capital in a systemic risk scenario.
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Currency: Large bond issuers typically issue in USD, EUR,
and GBP, allowing investors to implement their views on
different risk-reward trade-offs between yield and spread.
This is especially relevant at a time when central bank policy
paths are diverging markedly, with the Fed and the Bank of
England heading toward tightening, while the ECB continues
to ease policy.
Important differentiators
In our view, high-yield financials are very different from
high-yield corporate bonds in several respects that matter
most to investors, namely:
Business profile of issuers: Financials issuers tend to
be larger and better rated organisations compared to the
average medium-sized corporate high-yield issuer.
Systemic importance of issuers: Until the current
period of extraordinarily low GDP growth and inflation
turns decisively, we consider that the systemic crisis is
on-going. In this scenario, with the ECB still in easing mode,
even a medium-sized bank can be considered to be of
systemic importance.
Issuers’ access to the equity market: A large proportion
of bank issuers are listed companies able to raise equity to
recapitalise themselves in case of need. The regulatory push
to unwind overly complex holding company structures is
encouraging more banks to list their stock.
Regulation: Bank regulation is becoming more intense
and intrusive, particularly with the ECB taking over as the
single supervisor for systemically important banks.
Access to central bank liquidity facilities: For some
years to come, despite legislation allowing for senior bail-in
from 2016, it is likely that banks will receive central bank
liquidity support to prevent senior debt haircuts.
Exposure to the economic cycle and credit cycles:
While banks typically do suffer somewhat higher loan losses
during recessions, banks are normally able to retain earnings
or raise capital to deal with such losses, thereby protecting
subordinated debt investors. Only once in several recessions
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has a credit crisis reached such magnitude that several bank
subordinated debt issues faced coupon or principal losses.
In this sense, high-yield subordinated debt and corporate
high-yield debt follow a very different pattern of defaults
and recoveries. We would therefore expect low correlation
in defaults during the next recession, particularly because
banks are likely to benefit from much stronger capital levels
by that time.
Exposure to rising interest rates: Rising interest rates
are typically bad for high-yield corporate issuers, as the cost
of funding increases. However, banks typically benefit from
higher rates as their net interest income (interest earned on
loans less interest paid on deposits) rises.
Given the significant differences in fundamental credit
drivers discussed above, we expect that the default rate and
returns on financials and corporate high yield are also likely
to diverge materially at times of trend economic growth
and probably during normal recessions. However, as during
2008, we would expect that at a time of extreme systemic
crisis, both corporate high yield and financials high yield are
likely to sell off in sympathy with stocks.
To sum up
In our view as presented in this paper, the three key critical
issues for investors to consider are:
 High-yield financials is a large sector, which we believe has
the potential for strong growth through new issuance over
the next five years.
 The underlying credit and return performance drivers for
high-yield financials differ materially from the drivers that
apply to high-yield corporates.
 High yield financials currently offer attractive yields, with
many issuers strengthening their credit quality.
We expect investors who put in the effort to create a new
bucket for high-yield financials in their asset allocation mix
are likely to be rewarded as they can access attractive fixedincome returns with, in our view, potentially low correlation
to high-yield corporate returns.
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