Developed Market Credit

While third-quarter earnings across many European banks declined, what went almost unnoticed by newspaper headlines was that in the majority of cases the same banks further strengthened their core equity tier 1 capital (CET1) over the course of the year, as well as during the weak third quarter. Most major banks have by now nearly reached the CET1 levels required by Basel III for 2018, and in some cases 2019. This story of capital strengthening has been playing out over the past few years and continues to benefit us and our clients by making our investments safer. With the focus moving onto Basel IV, this strengthening process will likely gain renewed attention in 2017, which we welcome.

Another significant event in 2016, which augurs well for 2017, was the European Central Bank’s clarification of its regulation around contingent convertibles (CoCos), removing some doubt about these instruments. Prior to these rulings, uncertainty around when discretionary and non-cumulative coupon payments can be cancelled resulted in heightened volatility during the first quarter of the year, ie the exact opposite of what regulators were trying to achieve with the introduction of AT1 CoCos. AT1 holders being senior to shareholders needed better protection. As such, Pillar 2 has been split into two parts, significantly decreasing the risk of not getting a coupon on AT1. In addition, the European Commission made AT1 coupons senior to dividend and bonuses payments in the case of a breach of the distributable restriction level. As such, the risk of not getting a coupon on AT1 has structurally decreased, something not yet captured by their spreads.

We believe that junior and hybrid debt remains attractive for 2017, especially that issued by financials, which includes not only banks, but asset managers, investment banks and insurers. Investors continue to shy away from these assets due to the lingering fears and headline news about troubled banks, such as the Italian Monte dei Paschi di Siena (which will end up being resolved). As long as one concentrates on the stronger institutions, these and a growing issuance of non-financial corporate hybrid debt will provide opportunities this year, especially as we expect global developed economies to remain healthy. Economic growth is now also picking up in Europe and this leads to stronger balance sheets.

With regard to interest rate, our investment strategy does not rely on our ability to forecast interest rates precisely. Instead, we aim to get the broad trend right, which we are expecting to be a gradual increase over the coming year, with the next Fed moves probably taking place slowly. At a 6% coupon yield in our portfolios, we believe that this yield cushion could even withstand a more aggressive tightening, while our floating rate notes will actually benefit from any increase in interest rates, acting as a hedge. In any case, our broad portfolio mix of around 50% allocation to fixed-rate bonds and 50% in fixed-to-floating and floating rate notes should allow us to weather even a substantial rise in 10-year US Treasury yields up to around 3.0% (currently at 2.5%).

Away from an aggressive rate hike scenario, we expect markets to calm somewhat following the Trump election euphoria and for some realism to set in, as it will take time for the new president to start delivering on his promises, such as increased infrastructure spending.

Generally speaking, as buy-and-hold investors we welcome higher interest rates as these lead to higher coupons and hence enhanced income generation. So the challenge is to successfully manage that transitory period, protecting the average prices of our holdings until we reach this higher plateau for interest rates.

In summary for 2017, we are looking forward to higher coupon income and strengthening economies, which is helpful for credit. We also expect increased issuance as junior and hybrid debt continues to gain wider acceptance as a distinct asset class and as a useful diversifier in bond allocations alongside other fixed income categories.

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