Lending to the world’s biggest borrowers

Naturally, this attracts a significant amount of focus and scrutiny from bond investors. Another reason why banks are generally larger constituents of bond indices than of equity indices is that they have to issue bonds of varying levels of seniority to ensure that they meet regulatory capital requirements that are constantly changing depending on the mix of loans they’ve made and the whims of regulators. This also means that they are among the most frequent corporate bond issuers – another reason that they tend to be in frequent focus for bond investors.

The risks associated with bank debt vary significantly, depending on what security (if any) is offered in case of default and whether there are spicy bits such as embedded options. But the seniority of the bond is by far the biggest driver of its riskiness. For instance, right at the bottom of the debt capital structure sit AT1 bonds (or Cocos as they are sometimes known, short for contingent convertibles). This class of bonds received a lot of news coverage earlier this year as investors in Credit Suisse AT1 bonds were wiped out following the bank’s enforced takeover by UBS. A bond that can be completely written off in a stressed takeover is pretty risky!

Cover your … assets

At the other end of the risk spectrum are covered bonds. These bonds have ‘dual recourse’, meaning you have near-first dibs on a failed issuer’s assets to get your money back, as well as a preferential claim to a separate ‘cover pool’ of mortgage loans or other high-quality assets that are ring-fenced in an insolvency. There are also rafts of bonds that slice every conceivable level of seniority between these two extremes. So as you can see, we aren’t short for choice and can vary our exposure depending on our economic outlook at a given time.

While some idiosyncratic issues have flared up in the banking sector globally this year, we think UK/European banks are in generally good shape. Their earnings have benefited from higher interest rates, which have fed through to a better net interest margin (the difference between what they pay to borrow and what they charge their customers). Meanwhile, the quality of the loans on their books hasn’t deteriorated anywhere near enough to cause us any degree of alarm.

Now, you could argue that we should expect to see the quality of banks’ assets (the loans they’ve made) deteriorate from here as higher borrowing costs start to bite customers. However, we think it’s extremely unlikely that we will see anything near the size of write-down that could seriously jeopardise lenders’ solvency. We think it’s sometimes forgotten quite how different banks’ capital positions are compared to before the Global Financial Crisis. The results of the Bank of England’s latest UK Banking Sector Stress Test, released this summer, remind us of the resilience of the eight largest banks in the UK. All eight banks’ Common Equity Tier 1 ratio (CET1, or broadly the retained equity in the company, divided by all the loans it’s made adjusted for their riskiness) were comfortably above the 6% to 8% ‘hurdle’ rate after modelling for a severe economic downturn. The stress test also took into account how bank management teams say they would react to the shock, through a mixture of cutting dividend payments, employee bonuses and coupon payments where necessary and possible, and reducing loan books by halting new loans or selling old ones.

Furthermore, when you look at the CET1 ratio for all eight banks combined, its fall in the latest stress test was smaller than in the 2019 test. This shows that lenders’ assets are of higher quality today than they were in 2019. It’s worth highlighting just what this stress test entails, as many of the assumptions are more severe than those experienced in the GFC:

- Inflation averages 11% over the first three years of the scenario, peaking at 17%
- UK GDP contracts by 5%
- Unemployment increases to 8.5%
- Residential property prices fall by 31%
- Equity prices fall over 40%

Given the severity of this scenario, we think the results highlight the current strength of the banking sector.

All the above being said, bonds issued by banks (bar those at the very top of the capital structure) tend to trade with a higher beta, meaning they are more volatile than the wider market. However, when we look at the yields that are on offer in this sector, we think we are more than compensated for this extra volatility, particularly given the comfort provided by the stress test results in respect of their ability to weather an economic downturn.