European high-yield financials—A growing asset class
Satish Pulle, head of Financials & ABS, Portfolio Manager at ECM
Subordinated bonds issued by financial sector companies, predominantly banks, are expected 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.
High yield financials is a large and growing asset class
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. 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). We have also seen a significant growth in recent years of Contingent Convertible (CoCo) bonds. This growth has led to the launch of a Merrill Lynch CoCo index in January 2014.
Issuance will continue to be strong in the future
The 2008 financial crisis has 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. 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.
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.
Weaker peripheral countries such as Portugal and Spain are also likely to need to issue Tier 2 bonds together with issuance from emerging market banks such as Russia, Turkey and India. Based on the above broad brush analysis, we believe high yield 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.