In a world where USD12 trillion of fixed income assets are negative yielding, bank capital in the form of coco bonds stands out as a unique risk asset. We believe cocos offer alpha-generation potential and an attractive yield, in a sector with improving credit fundamentals. Here’s our take on the macro factors supporting the asset class and how we’re positioning to optimise risk-adjusted returns.
The macro environment
- The turnaround in global monetary policy drove positive returns across almost every asset class in 2019, precipitating sharp declines in long-term yields and easing financial conditions.
- Several major emerging markets are now recovering from recession and the slowdown in Europe appears to have troughed, if not stabilised.
- However, ongoing geopolitical tensions and the low-growth / high-debt stance across the world suggests the environment remains vulnerable to shocks.
- We anticipate the global monetary stance remaining on the current ‘glide path’ for the time being.
In our view, growth appears to have reached an inflection point and is showing signs of a stabilisation, central bank policy remains extremely accommodative and recessionary risks are abating.
Our macro base case
We anticipate that rates at the front end will remain anchored for the best part of 2020 and that growth will continue to modestly rebound – ‘goldilocks’ for credit remains our central scenario.
However, with yields already at historic lows and geopolitical tensions ongoing, we are mindful of the risks and the tightrope the global economy continues to walk.
Cocos – the investment case
- The yield proposition looks increasingly attractive and disconnected from the inherent risks in the AT1 instrument, in our view.
- The banking sector continues to strengthen fundamentally and should benefit in the event of a rise in interest rates.
- The asset class has favourable demand/supply dynamics and holds an alpha-rich opportunity set.
- Growth-sensitive credit has historically outperformed as recession risks recede.
How will we invest in 2020?
We remain convinced that our investment process of taking concentrated conviction views driven by in-depth bottom-up research with an overlay of macro, political and regulatory analysis, is the right one and will continue, in our view, to put us in a position to generate alpha and optimise risk-adjusted returns.
Our base case that we see low-but-positive growth, supported by accommodative monetary policy, warrants us to maintain our bias towards European bank cocos.
In our view, cocos remain a structurally mispriced asset. Expect us to show a preference for EUR and GBP securities over USD to take advantage of this arbitrage opportunity while it exists.
We continue to believe the market has mispriced call optionality, extension risk and bond-specific structural features such as resets. As such, our bias to securities with longer duration, fewer call options and structurally superior features will remain.
In a year where the demand/supply dynamics look to be especially supportive, expect us to be fully invested the vast majority of the time and to manage through any periods of market dislocation by using the full tool box available at our disposal to protect returns, rather than retaining high cash balances.
While this may at times feel uncomfortable, we are convinced that this approach will prove beneficial over the medium term.
In our view, legacy securities have never proven a fertile hunting ground but the closing window for these to provide banks with regulatory benefit is increasing the likelihood of management action that may prove rewarding for investors. It is highly unlikely that this will ever form a core part of our investment portfolio, but we will continue to scour the universe and be opportunistic should attractive investments present themselves.
Conversely, national champion banks with robust credit profiles will continue to form a core part of our investment strategy.
That said, the more stable economic environment merits giving some consideration to banks that are exhibiting notable improvements in their fundamental credit profile that are still to be recognised by the market. The growing potential for domestic M&A and a consideration of the banks involved and potential re-rating on a transaction is also likely to deserve some attention.
Valuations warrant an ongoing bias to the periphery but as beta is extracted from the market expect to see our strategy increasingly rotating into lower-beta jurisdictions.
Similarly, expect positioning in the UK to be adjusted tactically over the course of the year as Brexit newsflow progresses. Positioning will always be undertaken with a focus on alpha generation and the optimisation of risk-adjusted returns.