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Fixed On Bonds

Premier Miton's Bond Blog


Scaling the wall of worry


Back in March, shortly after Russia had invaded Ukraine, driving both energy and food prices higher, I wrote that the sharply negative reaction in markets might have been driven by fears over the sustainability of bank dividend distributions to both their shareholders and AT1 bondholders. AT1 bonds are a debt instrument through which large capital can be raised. Unlike other bonds, these do not have a maturity date, which means that the issuers do not have to pay the principal amount.

Double jeopardy

The threat came from two angles. First, would the economic slowdown brought about by the invasion stay central banks’ hands, and so reduce the likelihood of interest rate rises? This would have a direct impact on the profitability of the banking system through lower interest margins.

And second, would that same slowdown wreak havoc with the bad debts incurred by the system? This effect, while it may be delayed, would be picked up in forward looking reserving provisions by the banks, also hitting their profit margins.

Sticking to their knitting

As it turned out, central banks around the world were not swayed, they stuck to their proverbial policy knitting. The threat to stability from rampant inflation trumped the economic shock from a slowdown. Once again governments stepped in to support both consumers and businesses by subsidizing energy bills.

This move gave the central banks room to tackle inflation through base rate rises, stifling demand. Between mid-March and today, the base rate in the UK has increased from 0.50% to 3.00%, including a 0.75% rise in November. The ECB’s Deposit Facility rate has moved from -0.50% in July to +1.50% currently, and the Fed Funds Target rate in the US has also moved from 0.25% to 4.00%.

These are dramatic rises in such a brief period of time and are designed to bring demand back into line with reduced global supply of goods. Inflationary pressures had already been building as the world reopened from its COVID induced shutdown, and the Ukraine conflict only served to exacerbate that problem.

Building a balance point

Clearly these rises are having an effect. Unions are calling for strike action in many countries as wages fail to keep pace with reported inflation. But to quell demand, that is the desired effect. Demand must be reduced to bring it into line with supply, which means lower levels of consumption, at least for a period until supply chains can reconfigure.

“Fool in the shower” is a metaphor attributed to Nobel laureate Milton Friedman, who likened a central bank that acted too forcefully to a fool in the shower. The notion is that changes or policies designed to alter the course of the economy should be done slowly, rather than all at once. The expression is best summed up as the scenario when central banks or governments overreact to swings in the economic cycle without waiting to gauge the impact of their initial actions.

With lower levels of consumption being a result of the cheap monetary taps being closed unfortunately there will be economic casualties. Businesses will fail, and there will be bad debts that will hit the system. This always happens as economies slow. But how bad will it be?

A well-versed boom and bust cycle

While I do not possess a crystal ball, the worst busts come after extended booms. The playbook is well thumbed. A boom involves banks lending to progressively weaker and weaker lines of credit in the misguided belief that nothing can possibly go wrong. Capital is spread ever thinner, and to fund the loan growth there is greater dependency on markets for funding. When the slowdown hits, the weaker credit lines are the first to fail, and with little capital left, banks struggle. To make things worse the market-based funding becomes more expensive if it is even there at all. If it is not the bank does not last long, witness Northern Rock. That is how it normally works. Why buy into banks ahead of that?

This time may be different.

The banks are heading into this slowdown full of capital after 15 years of rebuild, post the global financial crisis. They are also carrying a healthy level of deposits following the various quantitative easing and furlough schemes that we have seen.

As a result liquidity is also very high. And most importantly, the one piece of the puzzle that has eluded them for the last decade or more, profitability, is returning with a vengeance. Bank’s make most of their income from the difference (spread) between what they charge for loans and what they pay for deposits. The rate charged on loans is linked to base rates, and so has fallen for years. The price paid for deposits, however, got stuck when it hit zero. In very few places were the banks bold enough to charge for holding customer deposits. Margins got squeezed very painfully, and there was nothing banks could do except focus on their cost bases and invest in digital banking.

As a result today they have lean cost bases and their loan pricing is rising again as base rates rise. On the deposit side, with so many deposits in the system, competition for them is very low. Margins are widening, and they are widening fast. We have the odd situation of the banks heading into a slowdown with unusually strong balance sheets and rapidly rising profits.

Why was there the big sell off?

This is mainly behavioural inertia. There is an entire cohort of investors for whom banks are not of investable quality. That has been the case for 15 years. As with IBM in decades past, you did not get fired for not holding banks. But it is hard to continue to ignore the numbers. As every quarter goes by, the numbers continue to exceed expectations, and the distributions grow.
In AT1 bond land, the yields on offer now exceed those available at the inception of the product, in the teeth of the European Sovereign Crisis when there was serious doubt over the future of the system. Rates are higher today, but yields are in double digits. We have even seen recently the first national champion bank to issue a bond with a 10% coupon. Carpe Diem.

Rob James


The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.


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