Financial Matters: It Pays To Dig Deep

by: AllianceBernstein (AB)

By Steve Hussey, Head of Financial Institutions Credit Research

Europe's banks are once again under pressure. This sector-wide weakness is opening up selective buying opportunities-as long as investors understand that the bank bond rulebook is changing.

The Flight from Financials

Europe's banks seem stuck in a losing streak. Bank stocks have underperformed this year, and bank bonds are also under pressure. Value-oriented equity investors are finding this weakness is opening up some buying opportunities.

Meanwhile, yields on some bank bonds may look enticing, but investors need to tread carefully.

At this point in the credit cycle, and given big changes governing European bank securities in the wake of the global financial crisis, new considerations have come to the fore. Investors in bank bonds need to dig extra deep. They need to scrutinize not just lenders' credit fundamentals and business models, but also be increasingly careful about what kinds of bank debt subclasses they invest in.

In particular, investors need to identify how each subclass might fare now that there are new ground rules governing any future bank failures in the form of Europe's Bank Recovery & Resolution Directive (BRRD). This step is critical, given increased risks that bondholders could end up nursing outsized losses if a regional bank were to fail.

The Big Bank Bond Bail-In

The tougher regulatory backdrop has pushed many banks out of riskier lines of business, forced them to sell their riskier assets and obliged them to build up their equity capital buffers-good news for bondholders as it's theoretically made bank defaults less likely.

At the same time, there's been a regulatory impetus to shift the burden of any future bank failures away from taxpayer bailouts and on to bank creditors-which is known as "bailing in" bondholders.

This regulatory impetus has driven many European banks to issue more so-called "bail-in-able" bonds, ranging from Additional Tier 1 (AT1) through to Tier 2 and senior unsecured securities.

Some bail-in-able bonds are designed to soak up losses by converting to equity, or being written off entirely. The new-form AT1 bonds would be at the sharp end of any loss absorption-their coupons can be turned off and they can experience principal losses. But T2 and senior bank bonds have also grown more vulnerable to potential losses.

The BRRD framework and new paradigm of bondholder loss-sharing have been brought into focus following enforced bondholder writedowns at Portugal's Novo Banco and some small Italian regional banks.

At the same time, the writedowns have sharpened investor attention on the underlying problems in the banking sectors of some European countries. In many, lenders hold worrisome levels of potential bad debts, or non-performing loans (NPLs).

And because many European banking markets are both overcrowded and fragmented, it's tough for lenders to earn decent profits and revenues and thereby bolster their resilience to a broadly challenging backdrop for banks as global growth sags.

Hefty Headwinds

Portuguese and Italian banking woes have proved a point of focus for broader investor unease about the outlook for Europe's banking sector as a whole-which is facing hefty headwinds.

With European interest rates now at all-time lows (even negative in a few countries), banks are being obliged to charge rock-bottom interest rates on their loans-which is eating away at their profits. And because growth is weak, it's hard for regional banks to win new business, particularly in countries where banking is a crowded playing field.

Banks' exposure to potential NPLs is also worrisome, particularly the risk of big losses on lending to the troubled energy and commodities sectors and to some emerging markets.

The U.K.'s upcoming referendum vote on whether or not to remain in the European Union (NYSEARCA:EU) makes the backdrop for regional banks still murkier. A vote to exit (or "Brexit") would exert big pressure on U.K. banks in particular, but resultant uncertainties would likely weigh on the Europe-wide banking system for some time.

Over and above these shorter-term pressures, the banking industry as a whole is confronting big secular changes as technology drives customers to fulfil their banking needs in dramatically different ways.

Financial technology startups ("fintechs") are challenging many crucial lines of banking business. As a result, Europe's banks are investing heavily in technology to counter digital disruption to traditional business models (some are buying stakes in fintechs). The resulting cost burden is weighty because new technology brings new vulnerabilities-which require expensive cybersecurity.

The Growing Banking Gap

With so much in flux and formidable headwinds challenging Europe's banking sector as a whole, we're seeing a widening gap opening between banks that look well-placed to thrive-and others that are more likely to lag.

We favor those banks that "stick-to-their-knitting" in long-term profitable lines of business where they enjoy scale and strong market positions. These banks enjoy good pricing power, which should bolster their profitability prospects.

And banks with the flexibility to up their fee-earning wealth management and private banking services are in a good position to offset pressure on their interest-earning business. Technological prowess is a further key differentiator-as long as customers are confident about cybersecurity.

In our view, the gap between Europe's likely banking winners and its likely laggards suggests investors should focus attention on a core shortlist of banks with supportive underlying fundamentals. And in the current environment of more bail-in-ability, it's grown increasingly important to dig deeper still and work out just how bailed-in your bank bonds could prove.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.