Why European banks’ fundamentals are strong
European banks are currently demonstrating unprecedented resilience, offering compelling opportunities for subordinated debt investors. According to Romain Miginiac, the banking sector’s return on equity (ROE) is expected to remain above 10% over the next 12 months, a notable improvement compared to pre-interest rate hike levels, when ROE ranged between 6% and 7%.
Evaluating CoCo AT1 valuations
The spreads of CoCo AT1 securities, while cyclical, stand at approximately 310 basis points, making them attractive given the sector’s solid fundamentals. Historical events like the Credit Suisse crisis pushed spreads above 600 basis points. However, the current narrow spreads call for caution as they approach the lower end of historical ranges.
GAM’s investment strategies
During the Credit Suisse turmoil, GAM capitalized on attractive CoCo AT1 valuations, increasing exposure to up to 60% and securing double-digit returns on high-quality issuers. With recent market rallies, GAM shifted to a more conservative approach, reducing CoCo AT1 exposure and reallocating funds toward Tier 2 and senior unsecured bonds, effectively mitigating downside risk while maintaining market flexibility.
Extension risk as a key indicator
Extension risk, a vital indicator for GAM, measures the percentage of CoCo AT1 securities priced at perpetual or call value. Currently at 10%, it suggests that most upside potential is already priced in, leaving returns more asymmetrical with greater downside risk. As a result, GAM maintains a defensive stance, focusing on secure valuations that balance risk and reward.
A prudent strategy moving forward
Credit markets are cyclical, and while spreads remain tight, a conservative strategy enables optimal risk-return balance. As Miginiac highlights, dynamic allocation management can capitalize on market volatility while safeguarding against excessive risks.
