Axiom European Financial Debt Fund — Bank resilience provides premium yields

European bank balance sheets remain strong and healthy. The eurozone bank average common equity tier 1 (CET1) ratio was a robust 15.0% at the end of H122, compared to 14.9% 12 months before. Non-performing loans (NPL) have declined to 1.85%, the lowest in more than a decade. Leverage and liquidity coverage remain good.

Eurozone bank ROE in Q222 was 7.6%, which is above pre-pandemic levels (6–7%) in 2018 and 2019. The banks had a cost to income ratio of 62% (lower than pre-pandemic) and cost of risk at 52bp (57bp in Q122 and 66bp in Q120 pre-pandemic).

Banks are by their very nature highly cyclical businesses and are therefore affected by the current economic downturn. As it takes time for loan impairments to make their way to bank balance sheets and income statements (although IFRS 9 rules do bring forward some of these impairments), the market is, of course, already looking ahead and trying to price in the downturn damage.

Inflation is not usually a top concern during periods of economic slowdown and recession. This time, however, it is, and the prospect of interest rates further rising is adding to the overall uncertainty and market volatility.

The inflation newsflow in recent months has generally been worse than expected, although the Citi Inflation Surprise Index (Exhibit 3) shows the scale of the negative surprises is dropping. Market expectations regarding the peak of the hiking cycle next year have therefore increased.

Exhibit 2 shows the trend in policy rates (US Federal Reserve, European Central Bank (ECB) and Bank of England) expectations over the last three months. We have used the policy rates being priced in for July 2023 through overnight index swaps. The market currently is pricing in that the US Federal Reserve and the Bank of England policy rates will be close to 5%, with the ECB’s at just under 3%. The UK rate expectations have been particularly volatile recently due to the UK government’s mini-budget crisis in October. The negative financial market reception, during which the future policy rate forecast spiked to 6%, ultimately helped bring about a change in leadership of the UK government.

Consensus GDP growth forecasts have also deteriorated in Europe and the United States. Whereas previously the market was forecasting modest GDP growth of 1–3% (International Monetary Fund and Refinitiv) for 2023, the forecasts are now generally of either stagnation or, in some countries such as the UK and Germany, mild recession.

The key issues facing the European banks include negative real wage growth, higher funding costs for borrowers (a problem more acute for vulnerable business sectors, such as energy-dependent ones) and the uncertainty of the degree to which the central banks (as well as government fiscal policies) must act to apply the brakes to arrest the persistent inflation.

The Bank of England on 3 November stated that it expected a two-year recession and specifically guided on the peak policy rate being 4.5% next autumn.

We see some regulatory risk in the medium term as the ECB is likely to limit banks’ windfall profits (as rates increase and the net interest margins widen) from changes to its ultra-cheap loans to the banking sector (through its targeted longer-term refinancing operations, TLTRO) and remuneration on excess reserves. The ECB increased costs and tightened conditions on TLTRO funding in the latest ECB meeting on 27 October and added new voluntary repayment dates. The new rules will encourage banks to repay some of this funding ahead of schedule. However, there were no changes made on remuneration on bank excess reserves with the ECB.

We also believe some governments are likely to choose to introduce bank levies on potential windfall profits. For example, the UK government has floated the idea, Spanish government is set to introduce one (although the ECB has warned against it) while the Hungarian government has already acted.

Despite the deterioration in the macroeconomic outlook over the last six months, we think that on balance it is still relatively supportive of banks.

Unemployment will likely climb but is expected to remain on the low side, and this is important for NPL formation on the retail side. The higher interest rates help bank profitability by boosting interest margins that have been compressed with such low rates. We think central banks will be pragmatic and not raise interest rates to levels that will be more harmful to the economy than the inflation. As a result, we would not be surprised to see inflation brought under control by central banks, but for it to be above average levels for a few years.

Our thesis remains that the challenges for banks are at the earnings level and not at the regulatory debt level. There might be some cases where a bank’s regulatory capital will be called to sustain losses, but in general we do not expect to see any bank losses in the sector being of the scale requiring this. In fact, the talk about bank tax levies reflects concerns with excess banking profits. We therefore continue to believe that while bank sector earnings will be lower and dividend payments may be cut, regulatory payments should continue as they did during the pandemic.

European bank regulatory debt has continued to outperform several of the other debt classes, but this is in the context of the tough bear market affecting the fixed income market at all levels of risk starting from sovereign. Higher inflation and higher rates expectations coupled with asset quality concerns have been driving down prices in global debt markets. This bear market comes after an extended bull run that pushed yields to unsustainably low levels in most debt classes.

The ICE BofA European bank (investment grade only) contingent bonds index is trading at a yield of 7.0% at the end of October, having been at 3.7% at the beginning of the year, and indicates the type of asset repricing that AXI has had to face. However, the move has been even greater in the high-yield bond segment; the European non-financial high-yield index (also by ICE BofA) moved from 3.2% to 8.2% in the same period (Exhibit 4).

AXI reiterated in its latest (September) monthly commentary that ‘fundamentals remain bullish for European banks’. It expected Q3 and Q4 results to reflect ‘the continued expansion of volumes and margins as well as low and stable default rates’. So far in the Q3 earnings season, we note this has been the case for most of the European banks.

AXI expects markets to remain volatile and vulnerable to ‘fear mongering, speculative attacks and negative feedback loops’. One of the examples it gave was the unsubstantiated rumour in September that Credit Suisse was insolvent.

AXI believes that banks have ‘ample’ capital and funding buffers to enable them to comfortably continue to grow their lending. It sees the higher interest rates as boosting bank interest margins and cushioning the blow from the expected higher loan impairments. In a call with Edison, AXI explained its view that European corporate credit problems are centred on vulnerable sectors as opposed to being broad based across the economy. In the retail mortgages segment, it sees greater risk in the northern European countries.

AXI believes how the US economy fares and how the US Fed acts to contain inflation will be paramount factors in shaping the global market’s performance in the coming quarters.

AXI noted that the market volatility has been a ‘source of profits for most trading floors’.

In terms of its sector strategy, AXI continues to believe that mid-cap origination offers particularly good opportunities in terms of yield and risk.

AXI’s weight of tier 1 debt instruments in its portfolio has remained relatively steady at about two-thirds of the portfolio and was 65% as of September. These bonds are Axiom’s core and largest investment space and include legacy (Basel 1–2) and Basel 3 compliant (AT1) bonds.

AXI had 28.4% in tier 2 instruments and 12% in straight senior debt. Equity holdings are close to zero at 0.1%. The UK continues to be the largest geography, accounting for almost 50% of the portfolio and this changed little over the last year. The remainder is diversified across several European countries as shown in Exhibit 11. Euro exposure is 48% (slightly down from 51% in March 2022), but foreign exchange (FX) exposure is substantially hedged to the pound sterling through FX forward agreements.

The portfolio split between strategies is shown in Exhibit 6 and has also remained relatively constant this year. Mid-cap investments represent 43% (was 44% in March 2022) of the portfolio. Restructuring stories are 29% and relative value strategies account for 31%. The ratings distribution is shown in Exhibit 8. Due to the loss absorbing and subordinated nature of regulatory capital debt, most of it is not rated as investment grade due to higher risk profile of regulatory capital. An institution’s senior debt can be investment grade, but not its regulatory capital.

Although AXI is not benchmarked against any index, the managers use the ICE BofA European Financials Index as a reference point. AXI’s shares and NAV have substantially outperformed this index over the last five years, as shown in Exhibits 13–15. Although in recent months AIX’s shares and NAV have also declined, the outperformance reflects the strong fundamentals of the underlying assets as well as the better relative valuation of European regulatory debt as an asset class.

Exhibit 14 compares the performance of AXI versus two other bond indices: the ICE BofAML European financials subordinated debt index and the ICE BofAML general European high yield index. AXI’s NAV has also significantly outperformed these two indices over most time periods.

Exhibit 15 shows a comparison of AXI with a selected peer group of funds from the AIC Sector Specialist: Debt and AIC Sector Specialist: Financials sectors that have significant holdings in high-yield lending or similar investments. We note that there is not a pure European regulatory capital debt peer; AXI is unique. For investors seeking exposure to this asset class, AXI is clearly a more focused play than any of its peers.

The most comparable peers in the table are CQS (32% of fund is financials, but mostly UK), TwentyFour (33% banks), EJFI (fully financial, but exposure is mostly through collateralised loan obligations) and Henderson Diversified (20% financials, albeit it has significant US exposure).

We compare the performance over one year. We have also added longer time periods for the peers, to give greater context to the short-term performance data.

AXI pays dividends quarterly in April, July, October and January. It maintained its dividend during the pandemic and has been paying 1.50p per quarter since 2017. There have been years that the dividend has been covered by cash income (eg 2019, 2020 and 2021) and years when it has not (eg 2018 and H122).

AXI’s is now trading at a discount to NAV of 9%, which is at an elevated level due to concerns regarding the macroeconomic outlook. The discount was only 5% in February 2022, once the fear of the COVID-19 Omicron variant subsided. The regulatory debt instruments are all accounted as market value (level 1) assets.

AXI launched in September 2015 and is a Guernsey domiciled, London-listed, closed-end fund investing in regulatory capital securities in Europe. It seeks opportunities presented by Basel III and Solvency II transitions. It has a diversified approach across a broad range of subordinated debt issued by financial services companies. It uses five sub-strategies to obtain good current income and capital gains. AXI has a target return of 10% pa over seven years.

While the key investments targets are the regulatory capital instruments issued by European financial institutions, the fund will also invest in other debt instruments, such as senior debt, issued by these companies. AXI also invests in derivatives instruments (such as collaterised debt obligations, securities or derivatives) that are linked to regulatory capital instruments or other financial institution investment instruments. AXI invests in both liquid and less liquid instruments. For those less liquid (for example with mid-cap issuers), AXI will sometimes create a market if it can be done profitably.