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Fixed On Bonds

A Moment in the Sun

Rob James

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Being an analyst covering the banks sector has been a pretty thankless task for most of the last 14 years since the Global Financial Crisis almost destroyed the sector. Light touch regulation in the preceding years had left a bank system with extremely high leverage with little capacity to cope with losses should they arise. The opacity of balance sheets, replete with structured products that all interested parties thought were safe, brought the house of cards down. To preserve economies banks were bailed out by their local governments resulting in the nationalization of large tranches of the system.

Quite understandably regulators and governments responded to prevent a similar event from ever happening again. The remedy was more capital and smaller, more transparent balance sheets. While eminently sensible, balance sheets move slowly. An additional hindrance to the rebuild came in the form of conduct fines for earlier misdemeanours. PPI was the poster child, but there were others. For shareholders this process has been extremely painful. In mid 2007 the European bank sector (as measured by the EuroStoxx bank index) peaked at 491. Between 18th May 2007 and 30th March 2021, including all the dividends paid, the sector has rewarded its long-suffering shareholders with a return of -69.2%. Over the same period the wider market returned +60.4%.

But the medicine was taken, and the sector’s balance sheet rebuilt. As we left 2020 the strength of that balance sheet, as measured by the CET1 ratio, was at a post GFC high of 14.9%, up from below 6% in 2007.

The balance sheet, however, is only one half of the story. Profitability is the other. Banks make most of their money from interest income. Depositors earn lower rates than borrowers have to pay. Over the last decade, as interest rates have fallen, it has become progressively harder for banks to hold on to their margin. While loan rates have fallen, it has been difficult (or at least the banks haven’t dared) to charge their customers for holding deposits at the bank. There has also been cost pressure from increasing levels of compliance, to prevent future misconduct, but also from the changing nature of banking, as customer behaviour has shifted online, leaving the system bearing the costs of a largely redundant branch network.

And then, to cap it all, a global pandemic closed the world down. In March of last year, the future for the system, with possible high unemployment and commensurate loan losses, once again looked bleak. Prices for shares and bonds across the capital stack fell once again.

But a year on, and things have changed. Glimpses of the sun are being seen from behind the Covid thunderheads. Firstly, the colossal support packages rolled out by governments have, at least so far, prevented the rise in unemployment that the banks had feared. With furlough schemes in place, consumers acted rationally and saved money and paid off their most expensive debts – credit card balances have fallen sharply in the last year. Secondly, with a highly successful vaccine rollout in place, the UK is rapidly approaching a reopening, at least partially. Bond markets, especially at the longer end, are starting to discount that the pent up demand, coupled with the destruction of some capacity, will lead to an uptick in inflation. Long bond yields have risen across the world.

While this may cause pain in some places, for the banking system it is an easing of the seemingly relentless downward pressure seen for the last decade or more. A steeper yield curve will allow for higher interest margins and the end to the death by a thousand downgrades that the market has endured.

This can be seen in short term performance. Since the recent lows on 9th October 2020, the sector has returned 54.2% against a wider market that has reached +19.4%. In fixed income, the AT1 Coco index (in £ terms) has returned 6.5%, annualizing at 14.3%. These are exceptional returns in such short periods of time, but they reflect a decade’s worth of cynicism in the sector.

It is tempting to suggest that the recovery in the sector is over. We’ve missed the boat. But let’s not forget that the rather miserable performance comparison at the start of this piece included this recent recovery. When the tide turns, the waters rise for some time. Maybe we are getting a little more than just a moment in the sun.

Risks

Forecasts are not reliable indicators of future returns.

Government and corporate bonds generally offer a fixed level of interest to investors, so their value can be affected by changes in interest rates. When central bank interest rates fall, investors may be prepared to pay more for bonds and bond prices tend to rise. If interest rates rise, bonds may be less valuable to investors and their prices can fall.

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For Investment Professionals only. No other persons should rely on any information contained in this document.

Performance source: Bloomberg as at 30.03.21.

Whilst every effort has been made to ensure the accuracy of the information contained within this document, we regret that we cannot accept responsibility for any omissions or errors. The information given and opinions expressed are subject to change and should not be interpreted as investment advice. Reference to any particular stock or investment does not constitute a recommendation to buy or sell the stock / investment.

All data is sourced to Premier Miton unless otherwise stated. Persons who do not have professional experience in matters relating to investments should not rely on the content of this document.

Issued by Premier Miton Investors. Premier Portfolio Managers Limited is registered in England no. 01235867. Premier Fund Managers Limited is registered in England no. 02274227.  Both companies are authorised and regulated by the Financial Conduct Authority and are members of the ‘Premier Miton Investors’ marketing group and subsidiaries of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE.

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