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Some volatility in bank bond spreads is likely to persist towards year end against the backdrop of the ongoing inflationary and economic uncertainties. Preferred senior unsecured bonds could start seeing some relative underperformance
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The retightening trend of EUR bank bonds spreads, that set in early July ahead of the ECB meeting, has started to experience some headwinds since mid-August. Not only did the early opening of primary markets post summer weigh on performance, there have also been signs that economic growth may be slowing down more than anticipated. To name an example, two weeks ago the August decline in the ZEW index pointed towards worse economic growth expectations than during the Covid-19 pandemic in 2020. Albeit not as bad as the ZEW index, also last week’s flash composite PMI for August suggests the eurozone economy has tipped into negative growth territory again.
Meanwhile, the signs have become more worrisome that the high inflation is more persistent than thought and is turning into a phenomenon stretching well beyond high energy prices alone. This underscores the tough balancing act for central banks to curb inflation on the one hand, while on the other hand not suffocating economic growth by doing so. Isabel Schnabel’s speech at Jackson Hole this past weekend left, however, little doubt about where the priority of the European Central Bank should be, namely to act forcefully now to avoid losing confidence in the central bank’s willingness and ability to bring inflation back to target.
Until inflation is convincingly curbed, this will probably leave markets torn between the occasional (post-)rate hike optimism on inflation expectations, and periods of uncertainty regarding the monetary tightening needed to get a grip on inflation and the impact thereof on economic growth. As such, spreads will likely continue to move within the range seen for EUR denominated bank bonds since the end of May. Although with some widening from current levels, as inflation remains high, and central banks continue their tapering and rate hiking. In the case of a more significant recession we may see spreads widening more substantially through the range, and could approach the wide levels hit back in early July.
Despite the fact that the recent widening has impacted spreads across the liability structure, preferred senior unsecured bonds have continued to hold up better than bail-in senior unsecured bonds, both in terms of their absolute spread performance as well as relatively in comparison to their covered bond and T2 comparable. This is nicely illustrated by figure 2, which gives insight in the relative performance of French preferred senior and bail-in senior bonds versus covered bond and T2 comparables.
To this purpose performance is measured against a weighted combination of covered bonds and T2 paper, spread neutral versus preferred senior or bail-in senior bonds at the start of the year. The dark blue line in the chart confirms that the preferred senior bonds of French banks do trade relatively tight at the moment versus the covered bond/T2 comparable. Instead, French bail-in senior instruments (dotted blue line) currently trade a tad wider than their covered bond/T2 equivalent.
The relative outperformance of preferred senior unsecured instruments versus covered/T2 instruments is uniform across all countries. Preferred senior bonds are expensive for essentially every single banking sector. For bail-in senior instruments, the picture is a bit more diverse. In countries such as France, Germany, Finland, Denmark, Ireland and Austria, bail-in senior has underperformed the covered/T2 comparable on a year-to-date (YTD) basis. Instead, in the Netherlands, Sweden, Norway, Spain, the UK and Belgium, bail-in senior paper is more expensive compared to covered/T2 than it was at the beginning of the year. Italy is the only exception where both preferred senior unsecured bonds and bail-in senior bonds trade wider than the spread neutral combination of covered/T2.
That said, even in countries where bail-in senior bonds did outperform their covered/T2 comparable YTD, the outperformance of preferred senior versus covered/T2 has been stronger. This despite the fact, that the ECB restored the 2.5% collateral limit for eligible (preferred) senior unsecured paper per 8 July, down from the temporarily higher 10% limit applicable till then. In our view, preferred senior is, across the board, the tightest product on the liability structure in relative terms. This has different reasons:
While the absolute spread performance of bank bonds has been weakest further down the liability structure, there are a few countries that stand out for their almost equally soft performance in preferred senior as in bail-in senior. These countries include Italy, Spain and Austria.
In our view, there a different explanations for the comparatively weaker performance of preferred senior unsecured instruments from these banking sectors:
On 21 July 2022 the ECB added the Transmission Protection Mechanism (TPI) to its toolkit. The main purpose of the TPI is to counter unwarranted, disorderly market dynamics that are a serious threat to the transmission of monetary policy across the euro area. The TPI allows the ECB to buy public sector securities (ie, marketable debt securities of central and regional governments as well as agencies) with a 1yr to 10yr maturity from countries that experience a deterioration in funding conditions not justified by their fundamentals. The scale of TPI purchases will depend on the severity of the risks for the transmission of monetary policy. Besides, purchases will be dependent upon the ECB’s judgement that the applicable country does pursue sound and sustainable fiscal and macroeconomic policies. This conclusion will be based upon several criteria, such as 1) compliance with the EU fiscal framework, 2) absence of severe macroeconomic imbalances, 3) fiscal (ie, public debt) sustainability, and 4) sound and sustainable macroeconomic policies. Activation of the TPI is also dependent upon the ECB’s judgment that purchases under the TPI are proportionate to the achievement of the central bank’s primary objective. In turn, buying will end upon a durable improvement in the transmission of monetary policy, or upon an assessment that persistent tensions on a country’s funding conditions are due to country fundamentals. The ECB also clarified that purchases under the TPI would be conducted in a way that they would not cause a persistent impact on the Eurosystem’s balance sheet and monetary policy stance.
The ECB furthermore confirmed at its July meeting that pandemic emergency purchase programme (PEPP) reinvestment flexibility will continue to be the first line of defence to counter pandemic-related risks to the transmission mechanism. The ECB intends to reinvest redemptions under the PEPP until at least the end of 2024, while the future roll-off of the PEPP portfolio will in any event be managed to avoid interference with the appropriate monetary policy stance. Asset purchase programme redemptions will be reinvested for an extended period of time, following July’s rate hike, and in any case for as long as necessary to maintain ample liquidity conditions and an appropriate monetary policy stance.
Against the uncertain macroeconomic and political backdrop, bank bond spreads will remain susceptible to some volatility during the rest of this year. Preferred senior unsecured bonds may, in particular, suffer relative weakness on the liability structure, considering their tight spread levels and with supply set to pick up. Meanwhile, where it comes to the absolute spread performance this year, the preferred senior bonds of Italian, Spanish and Austrian banks are outliers on the weaker side, be it with good reason. With the exception of Italian bank bonds, this does not alter our opinion however that preferred senior is the most expensive of all on the bank bond liability structure.
Head of Financials Sector Strategy
Head Economist, Digital Finance and Regulation
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