Axiom European Financial Debt Fund — Expected to remain resilient

Banks and insurance companies are allowed to issue debt instruments that have sufficient equity-like features for them to be considered also regulatory capital. These debt instruments are a form of loss-absorbing capital that only suffers losses or modification once equity is wiped out or drops below certain thresholds. To qualify, instruments typically will be subordinated to secured debt, unsecured, offer variable non-cumulative coupons and be perpetual or of very long duration.

Although cheaper for the banks to issue than equity, these instruments typically command relatively higher yields than regular debt. The European regulatory capital debt market is a relatively sizeable one, which Bloomberg estimates at €800bn.

Regulatory rules have become stricter over time and, as a result, some instruments have seen their regulatory value decline. This can encourage banks to redeem the instruments that offer poor value compared to their regulatory value. In the appendix of our initiation note Capital opportunities, published on13 April 2021, we summarise the changes in regulatory capital, including the regulatory grading of these instruments.

It is a niche segment, where understanding not only banks but also trends in bank regulation can provide attractive investment opportunities. Bank balance sheets are now usually more robustly capitalised and business models de-risked since the 2008–09 financial crisis (the Global Financial Crisis, GFC).

Axiom (AXI’s manager) has a proprietary model that looks at various bonds to determine where opportunities exist, which ones are most likely to be redeemed and at what prices. Axiom uses five investment strategies, which we explain in the asset allocation section (page 6). These combine to generate strong, steady income through coupons and upside by AXI investing in special situations as well as restructuring (in terms of business model and operations rather than debt itself) stories.

The good news is that the balance sheets of European banks are strengthening as the economic recovery following the COVID lockdowns progresses. According to the European Central Bank (ECB), eurozone non-performing loans (NPLs) are at cyclically low levels of just 2% of loans (December 2021), while capital levels are at elevated levels (end-2021 eurozone banks CET1 ratio of 15.5%). Both figures are better than before the pandemic. The average sector ROE was around 7% in all four quarters of 2021.

Much of this success is due to regulation, changed business models (such as de-emphasising activities like proprietary trading or investment banking) and holding higher levels of capital on the balance sheet. It also resulted from pragmatic and timely support from central banks and governments during the pandemic.

Inflation has been surging to the point that consumption and GDP could be significantly negatively affected if price inflation continues to outpace wage growth. Interest rates are also rising, and this could put further pressure on consumers, especially with big ticket items like mortgages, which are often floating rate in many European countries.

Central banks have to perform a delicate balancing act. They must raise rates to rein in inflation, while at the same time take care not to apply too hard a brake on the economy. The situation is complicated by uncertainty around how much of current inflation is due to transitory reasons and how much will persist and be anchored in inflation expectations.

The transient element of inflation is driven by supply chain constraints as economies rebound from various lockdowns and consumers spend the money they saved during the pandemic. Some of the loss of purchasing power by consumers can be absorbed by using savings accumulated during the pandemic before consumption starts to drop.

These supply-side problems have led to soaring materials and food prices. Some have now subsided, but there are other sources of elevated inflation such as energy and commodity prices. These are also expected to come down as bottlenecks are resolved. The Ukrainian war has pushed up the price of oil, gas and food, but it is hoped that this will also be transitory.

Central banks have been quite accommodative (arguably excessively so) as inflationary pressures built up. However, central banks have started to raise their policy rates. The Federal Reserve’s upper bound and Bank of England target rates are both currently 1% (compared to 0% and 0.25%, respectively, at the end of 2021). The outlook is for further hikes and overnight index swaps are indicating rates of 2.8% and 2.2% in the US and UK by the end of 2022.

The ECB has been holding back and its target rate remains -0.5% with overnight swaps at -0.6% (as of 7 June 2022). Forward overnight swaps are indicating 0.67% by the end of 2022. This is still a relatively low level, and we feel it is quite an accommodative central bank stance.

In fact, despite the expected rate hikes later this year, real rates will continue to be negative even in the United Kingdom and United States. Nevertheless, these higher interest rates should contribute to a slowdown in the economy. US GDP growth in Q122 was already negative, while the Bank of England has indicated that it expects GDP growth to be negative in the last quarter of 2022. The Goldman Sachs US financial conditions index (Exhibit 4), which measures the availability of funding in the economy, has been rising to reflect tighter lending conditions and we are now moving closer to a neutral position.

Current macro consensus forecasts look relatively supportive of banks, but we believe they are likely to become more pessimistic. Just as consensus forecasts for inflation were seriously lagging actual market expectations, we believe growth forecasts are likely too optimistic. Published consensus forecasts (for example, central bank collected forecasts, by the IMF and on Refinitiv) are for the economic recovery to continue unabated in 2022 and for modest GDP growth (1–3%) in most European economies in 2023. Unemployment levels, key for the formation of NPLs, are expected to remain relatively low (Exhibit 5). Furthermore, higher interest rates help bank profitability by boosting interest margins that have been compressed by such low rates, with the significant caveat that interest rates do not climb to levels where they start to create asset quality problems.

Besides asset quality, there are other challenges facing European banks, including the need to cut costs and adapt business models to be more digitally focused.

We believe all the above results in a risk of sizeable earnings downgrades for many European banks for the next few years. At the same time, this seems more of a concern for equity investors rather than regulatory capital debt investors. There might be some cases where a bank’s regulatory capital will be required to sustain losses, but in general we do not expect to see any bank losses in the sector being of the scale requiring this. We therefore think while bank sector earnings will be lower and dividend payments may be cut, regulatory payments should continue as they did during the pandemic.

Fixed income prices have been falling in the last three months as the market prices in deteriorating inflation, interest and the macroeconomic outlook. This has taken place across the debt asset class and includes regulatory debt. However, European regulatory debt has performed better than some of the other debt classes. The ICE BofA European bank (investment grade only) contingent capital bonds index yield moved from 3.7% at the end of 2021 to 5.5% on 6 June 2022. In the same period, the ICE BofA non-financial high yield rose from 3.2% to 5.8%, a considerably bigger move. Exhibits 6 and 7 compare the two indices, showing their yields and the spread between them. The yield on the ICE BofA euro financial index (regular debt) was only 0.6% at the end of 2021 and is now 2.6%.

Axiom Alternative Investments is a Paris-headquartered portfolio management company founded in 2009 and ‘solely dedicated to the banking sector and to insurance companies’ in its investment scope. The team consists of regulatory capital specialists and experienced asset managers with an extensive understanding of the financial sector and regulatory issues.

AXI runs nine different funds (including one electronic-traded fund) with various focuses including debt, regulatory capital, equity, sustainable finance and long-short strategies. Some funds have a regional (European) focus while others are global. The company is regulated by the Autorité des Marchés Financiers, the FCA (it has a branch in London) and the SEC. It has a total of US$2.2bn of assets under management.

The manager’s view is relatively bullish, not just on regulatory debt but also on the equity story for European banks. First, AXI sees that SX7P (STOXX Europe 600 Banks Index) banks’ consensus earnings expectations for 2023 and 2024 are back to their highest in the year to date, having recovered all their losses since the Ukrainian invasion. The rebound is driven by higher interest rate (and higher interest margin) expectations. Second, default rates are still well below historical averages and better than banks' analyst expectations. In the most recent JP Morgan Default Monitor publication (May 2022), the 12-month trailing, par-weighted US high-yield default rate increased 20bp in May to 0.43%, to its highest level since September, coming off the lowest default rate on record in April. Notably, the default rate still remains well below the long-term historical average of 3.50% (based on 40 years of annual default rates back to 1980); the 25-year average default rate is a lower 3.07%. Third, it is encouraged by the European banking loan growth of 5.3% y-o-y in May 2022, which is the strongest for many years. AXI also notes that sector earnings forecasts for 2022 have only been cut by 3% since February 2022 and, as a result, the sector is trading at a 2022 PBV of 0.55x but an ROE of 8%.

AXI has also highlighted that bank balance sheets continue to be strong, with low NPLs and robust capital. In a call with us, it noted that Q122 numbers have remained relatively resilient for many of the banks.

AXI recognises the risk of economic slowdown and estimates that, based on previous recessions, a 1pp reduction in GDP growth could lower earnings expectations by as much as 8%; higher loan impairments reducing earnings by 5% while the remaining drop coming from lower loan growth and fees.

It believes that higher interest rates would more than offset the impact of lower economic growth. It forecasts a 25% pass-through improvement on bank interest margins from a 100bp parallel increase in interest rates. AXI also believes that ‘new guaranteed loan programmes and increased fiscal spending overall are likely to reduce provisioning needs and provide a boost to loan growth’. It therefore finds the underperformance of the Euro Stoxx Banks Index versus the broader European market since mid-February difficult to reconcile with rising German Bund yields.

It is cognisant of inflation and growth risks and of ‘downside risks ahead: high energy prices will hurt real income; rich real estate valuations could be tested by rising mortgage rates, resulting in lower perceived wealth and balance sheet quality; central banks may have to tighten aggressively into a recession if inflation does not settle down’.

However, AXI feels that the balance of risks is to the upside as ‘consumers have barely started to tap into their excess savings; high government spending is still irrigating the European economy and protecting vulnerable businesses; though manufacturing is operating above potential, less energy-intensive services are still operating below potential, offering significant real growth prospects as economies reopen; the labour market is still reasonably elastic, with more people continuing to join the workforce without unsustainable increases in wages; and inflation expectations are not unanchored’.

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

The weight of tier 1 debt instruments in AXI’s portfolio has remained relatively steady since September 2021 and was 65% as of April 2022. These bonds are Axiom’s core and largest investment space and include legacy (Basel I–II) and Basel III-compliant (AT1) bonds.

AXI also has increased its tier 2 debt from 18% in September 2021 to 27.3% in April 2022, while its position in straight senior debt has been relatively constant at 12.9%. It has cut its position in equity holdings, which was 5% in September 2021, to close to zero (0.1%) at the end of April.

The UK continues to be the largest geography, accounting for 50% of the portfolio, and this has changed little over the last six months. The remainder is diversified across several European countries, as shown in Exhibit 9. Euro exposure is 53% (up from 47% in September 2021), but foreign exchange (FX) exposure is substantially hedged to GBP through FX forward agreements.

The portfolio split between strategies is shown in Exhibit 8. There has been an increase in mid-cap investments from 26% in February 2021 to 36% in September and then to 44% in April 2022. As stated earlier, management believes that this segment currently offers particularly good value versus risk. Restructuring stories have fallen from 45% in February 2021 to 28% in April 2022. Relative value strategies account for 29% of the portfolio and this has been a relatively stable weight. The various strategies are described on page 11.

The ratings distribution is shown in Exhibit 10. Due to the loss-absorbing and subordinated nature of regulatory debt, most of it is not rated as investment grade due to the 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 very substantially outperformed this index over the last five years, as shown in Exhibits 15–17. Although in recent months AXI’s shares and NAV have 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 16 compares the performance of AXI against two other bond indices: the ICE BofAML European Financials Subordinated Debt and ICE BofAML general European High Yield Index. AXI’s NAV has also significantly outperformed these two indices.

Exhibit 18 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 Exhibit 18 are CQS (32% of the fund is financials, but mostly in the UK), TwentyFour (33% banks), EJF Investments (fully financial, but exposure is mostly through collateralised loan obligations) and Henderson Diversified (20% financials, albeit it has significant US exposure).

We compare performance over one year, but have added longer time periods for peers, to give greater context to the short-term performance data. AXI performance has been well above the average of selected peers.

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

AXI is now trading at an 9% discount to NAV, which is at an elevated level as a result of current concerns regarding the macroeconomic outlook. The discount was only 5% in February 2022 once the fear of the Omicron variant reduced. AXI traded at only a 10%+ discount during the peak periods of the pandemic fears. 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 strong current income and capital gains. AXI has a target return of 10% per year 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 derivative instruments (such as collateralised debt obligations, securities or derivatives) that are linked to regulatory capital instruments or other financial institutions 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 do so profitably.

The investment manager is Axiom Alternative Investments (Axiom) and the investment adviser is the Axiom Alternative Investments UK Branch. Although the investment management agreement is with the investment manager, the investment adviser also provides services and support.

The investment team is led by David Benamou (chief investment officer and managing partner of Axiom) and Jérôme Legras (head of research, managing partner), with Gildas Surry (AXI’s portfolio manager, partner) and, more recently, Antonio Roman as portfolio managers. Prior to joining Axiom, David Benamou and Jérôme Legras were managing directors and co-heads of the Capital Structured Finance department at Société Générale Investment Banking. They both designed and implemented many subordinated debt issuances for European banks. Jérôme was previously head of quantitative research at Société Générale. Gildas worked at Lazard Freres, Merrill Lynch and Citibank with a focus as an analyst on subordinated debt. Antonio joined Axiom in 2018, having previously worked at JP Morgan AM developing portfolio optimisation tools under insurance regulatory rules and at Goldman Sachs AM as a quantitative analyst focused on client solutions relating to institutional clients with unique economic, regulatory and accounting constraints.

Axiom is focused on the financial services segment and currently manages $2.2bn in assets across nine funds, the first of which was launched in 2009. These funds include one investing only in equity and a long-short debt fund. The team currently has 24 professionals.

AXI follows a three-step process: identifying the target investment instruments; portfolio construction; and portfolio monitoring.

Using in-depth analysis, Axiom looks at structure, regulation and risks when identifying new investments. Structure includes key terms, different types of call and issuer policies. Regulation includes regulatory category of issue, modelling of amortisation profiles and market mispricing. Risks include credit analysis, asset quality review reverse engineering and stress testing analysis.

Portfolio construction is carried out by the investment manager from the instruments recommended by the investment adviser. Portfolio monitoring looks at both the evolution of regulatory circumstances and the usual company, sector and market trends.

Investment decisions are taken by the investment team, which is neither required to, nor does it generally, take them to the board unless there are conflicts of interest or for the application of investment guidelines. David Benamou has veto rights at the investment committee level.

AXI uses five investment sub-strategies to obtain the mix of capital gains and current income that it seeks. These are:

There is no minimum portfolio weight for each of these strategies but there are caps. These caps are 20% for restructuring and special situations, 25% for liquid relative value and 30% for less liquid relative value and mid-cap origination. The current weights are shown in Exhibit 8 on page 6, and we note that the restructuring sub-strategy at 27.3% is above the stated cap of 11%.

AXI integrates ESG criteria in its investment in three ways: an in-house database and tools dedicated to ESG; engagement with management and investor relations for information; and information published in annual reports and other regulatory filings (including sustainability reports and task forces on climate-related financial disclosures). The ESG policy is detailed on the company’s website. Axiom partners with external consulting firms to assess its portfolio. It signed up to the Principles for Responsible Investment (PRI) in 2016. PRI is a United Nations-supported investor network committed to implementing its six investment principles, related to integrating ESG into investment decisions and policies.

As set out in its articles of incorporation, AXI is permitted to borrow in any manner. However, the board has limited this to 20% of its direct investments. At the end of FY21, AXI had £0.7m in bank overdrafts and £7.7m in cash for a net cash position of £7.0m (against a NAV of £96.9m). However, AXI uses derivatives (usually sales and repurchase agreement contracts) for gearing. The financial statement showed that at the end of FY21, AXI had a net derivative position of minus £2.6m with £4.1m in collateral assets used as margin.

AXI has an annual management fee of 1% of NAV that is paid quarterly and in arrears. This fee drops to 0.8% if NAV exceeds £250m on a marginal basis and if NAV exceeds £500m it is 0.8% for the whole NAV.

There is a 1.5% cap on total expenses. So, if in the final quarter of an accounting period total expenses (including management fee) exceed 1.5% of NAV, this is offset by the management fee being adjusted downwards.

The performance fee is 15% of the total shareholder return in excess of 7% per year, paid annually and subject to a high-water mark. The performance fee is not subject to the 1.5% total expenses cap. 50% of the performance fee is in cash, with the remainder in shares.

AXI currently has a single share class, with 91.852m ordinary shares in issue trading on the Specialist Fund Segment (SFS) of the London Stock Exchange. There are no rules restricting the ability of the directors to issue additional shares on a non-pre-emptive basis at any time. The directors may issue additional shares, pursuant to a placing programme or otherwise, if they determine that this is in the best interests of shareholders and Axiom as a whole. Since the IPO in 2015, there have been 30.9m shares allotted with proceeds of £32m, as shown in Exhibit 23.

AXI’s board comprises three non‐executive directors, all of whom are independent of the investment manager.

William (Bill) Scott, chairman: Bill is an independent non-executive director of a number of investment companies and funds. He was formerly senior vice president of FRM Investment Management, a leading manager of institutional fund of hedge funds in Guernsey and now part of Man Group. Prior to this, he was a director at Rea Brothers (which became part of the Close Brothers group in 1999 and where he was a director of Close Bank Guernsey). He is a chartered accountant, holds the Securities Institute Diploma and is a chartered fellow of the Chartered Institute for Securities and Investment. He is also a chartered wealth manager.

Bill currently serves on two other Premium London-listed fund boards: Pershing Square Holdings and Worsley Investors, and has served continuously on Premium London-listed boards for more than 18 years. He is also a director of RTW Venture Fund, which is listed on the Specialist Fund Segment of the LSE Main Market.

John Renouf is a qualified accountant and was also employed by FRM Investment Management as a director and then managing director. Prior to this, John was employed on a part-time basis by Collins Stewart to assist in its development of offshore funds and spent more 10 years with Royal Bank of Canada Offshore Fund Managers in Guernsey. In this role he had overall responsibility for the management and administration of Royal Bank of Canada’s offshore funds in the Channel Islands, together with funds managed and administered on a third-party basis. John currently holds a number of directorships of funds and fund management companies.

Max Hilton returned to Guernsey from New York in 2008 and formed the predecessor firm to Clarus Risk. He previously worked for JP Morgan Securities in New York in proprietary equities and was responsible for managing a global equities portfolio. Prior to this, Max had worked at Ziff Brothers Investments in New York and London as a senior associate in the quantitative strategy group. Max has a BSc (Hons) in Economics from the University of London and has held the CFA designation since 2001. Since 2009, he has served as chair of the CFA UK Performance and Risk Measurement Special Interest Group.