Subordinated bonds at attractive yields

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1 INVESTMENT OPPORTUNITY June 2015 For professional investors BY JAN WILLEM DE MOOR, PORTFOLIO MANAGER OF ROBECO FINANCIAL INSTITUTIONS BONDS Subordinated bonds at attractive yields Strong market momentum for financial bonds due to Basel III Banks capitalization is improving, while valuations are compelling Great client interest in new-style financial bonds The case for financial bonds is more compelling than ever. Having learned some lessons in the Great Financial Crisis of , banks and insurance companies have been tidying up their balance sheets, prompted by new regulations such as Basel III and Solvency II. While Basel III requires new types of bonds to be issued that offer attractive yields, increased supervision and regulation will substantially lower the risk of default. Not surprisingly, there is great client interest in these new-style financial bonds; Robeco Financial Institutions Bonds has grown to around EUR 1.4 billion in assets within the first four years of its existence. Diversified exposure to an attractively yielding sector For Robeco Financial Institutions Bonds we invest in the debt securities of banks and insurance companies, ranging from the newstyle hybrids - such as bonds that can be converted into equities - to traditional subordinated debt. The portfolio predominantly invests in European issuers. Basel III regulations require banks to have higher capital buffers to provide protection against unexpected losses. This has created a whole new market as the traditional subordinated bonds Investment Opportunity 1

2 have gradually been replaced with new types of capital particularly hybrid instruments, such as CoCos and Additional Tier 1 capital, which comply with Basel III requirements. We expect the issuance of these new-style Tier 1 bonds and Tier 2 bonds to continue, as banks will need to comply with the new Basel III capital rules by As subordinated financial bonds offer a higher spread than senior debt, this offers new opportunities for investors looking for higher yields. At the same time, the risk of default has actually declined as banks capitalization buffers have risen a lot in the past years, forced by, or in anticipation of, new regulations and shrinking balance sheets. In Europe, ECB supervision and increased regulation will substantially lower the probability of default as well. Insurance companies have also been boosting their capital reserves to meet the new requirements of the upcoming Solvency II regulations, which are scheduled to come into effect on 1 January This has led to the issue of Solvency II bonds by insurers. No do-it-yourself sector As the bonds have complex characteristics and the sector is highly diverse, a fund with a welldiversified portfolio, managed by a specialist team, can be a good alternative to managing your own portfolio. There are many pitfalls and risk mitigation is essential. Within our credit team, which consists of 21 analysts and portfolio managers, we have four dedicated financial analysts and two highly experienced portfolio managers for Robeco Financial Institutions Bonds, who look very closely at each and every financial institution we invest in. They carefully analyze the details of every instrument, sifting through the various prospectuses. Particularly in the financial sector it is just as important to select the right issuer as it is to choose the right bonds, as there can be significant differences in performance and risk between bonds of the same issuer. Risk management: state of the art Subordinated bank bonds come with their own specific risks, such as a coupon not being paid, or not being paid back on the expected call date. For Additional Tier 1 (AT1), for example, there is the risk that the bank s Common Equity Tier 1 ratio reaches a trigger point by falling below a certain threshold. In that case, the bond must be converted into equity or is written off. This is very likely to result in losses for the investor, so risk management is crucial. As hybrid instruments like AT1 offer attractive coupons, we see this as a calculated risk worth taking in those selective cases where capital buffers are sufficiently above trigger levels. In other words: we only buy AT1 (or CoCos) if we think that the likelihood of the bank falling to the trigger level is very small. The majority of the portfolio is invested in Tier 2 bonds. Although these are less risky, here too we make a thorough analysis of the risk characteristics. Other risks include spread movements which can be larger than for senior bonds, or the risk of regulations changing. It is therefore of key importance to have a welldiversified portfolio. The portfolio of Robeco Financial Institutions Bonds is spread over some 60 issuers. As a pioneer in credit risk management systems, we have a proprietary credit risk model, which uses spreads to capture market, sector and issuer volatility. This duration-times-spread approach is the most accurate and timely measure of risk. Risk management is fully integrated in the investment process, and the team closely monitors credit risk by focusing on avoiding losers, and limiting concentration risk in the portfolio. In addition, the team keeps an eye on market risk by limiting the exante tracking error to 4%, and liquidity risk by maintaining a limited exposure to a single issuer. Counterparty risk, operational risk and currency risk are also thoroughly screened. How do we manage the fund? As a starting point, we take the views from our Credit team s quarterly outlook to determine the overall beta ( risk budget ) of the portfolio. Secondly, our credit analysts perform an in-depth analysis of the financial institution s business position, strategy, financial position, corporate structure and ESG profile. Lastly we look at relative valuation of individual issuers and bonds, which includes an assessment of country risk, regulations, liquidity, business risk, spread, conversion trigger levels, etc. We base portfolio weights on conviction levels, risk attribution and concentration limits. Active duration or currency positions are not a component of this strategy. Country exposures are key The causes and aftermath of the global financial crisis have shown the pitfalls in the interlinkage between the financial sector and the sovereign. We therefore look at country exposures to account for differences in economic development as well as the quality of the sovereign, its institutional and its regulatory quality. For Investment Opportunity 2

3 Investment process Source: Robeco example, we prefer bank securities from the UK and the Netherlands, because we think their banks have been recapitalized relatively well. We are more conservative on banks in Spain and Italy, as may well be expected, but also in Germany. Loan losses in Germany are not really a problem, because the underlying economy is doing really well, but the profitability of German banks is low. Their structural problems mean German banks do not have much room to absorb higher loan losses, if they do come. Looking for solid capital loss absorbing buffers As for the individual bonds, we also need to consider what level of subordination we are comfortable with. One element we scrutinize is the composition of the loan book to see what kind of loan losses we can expect and to what extent the bank is able to absorb loan losses through its pre-provisioning income. So a bank might have relatively high loan losses, but if it is also earning a high interest margin, it would be able to absorb those loan losses. To give an example: in the portfolio we currently (May 2015) have a Crédit Agricole 8.125% Tier 2 Coco. The final maturity date is in 2033, and it is callable in The spread to call is approximately 260 bp, and increases to 628 bp if the bond is not called. Coupons cannot be deferred or canceled; the only risk is a write-down if the Common Equity Ratio drops below 7%. To reach this trigger level, a loss of EUR 15 billion is needed. Having analyzed, among other things, the loan book, we feel comfortable with this risk. Another portfolio position is the Axa 3.941% perpetual, callable in Axa is one of the largest European insurance companies, its business being well spread over different countries and different business lines. It has a solvency ratio of approximately 265%, which makes it a well-capitalized insurance company. The spread to call is 250 bps, which increases to 390 bps if the bond is not called. Coupons can be deferred, but if this happens, they must be paid at a later stage. There are no writedown features or bail-in risks. After analysis of all features, we are comfortable with the risk. Highly flexible zero duration solution As far as interest rate risk is concerned, the extra spread that subordinated financial bonds offer already provides a buffer to partially absorb higher interest rates. Next to that, we offer zero-duration solutions for clients who wish to protect their portfolio against interest rate rises. This highly flexible solution allows clients to switch between the regular share class and the zero-duration share class without additional costs. This means that the client can choose not to run interest rate risk, but still profit from the attractive credit spreads and dynamics in financial bonds. Consistent outperformance The fund has consistently outperformed its benchmark since its inception in May 2011, as shown in the table. These results are attributable to a combination of thorough research, good issuer selection and beta positioning. Current positioning We expect the asset class to continue to perform strongly over the next few years. For this reason we maintain our overweight beta positioning. The overweight is almost exclusively realized by Ann. returns Robeco Financial Institutions Bonds (EUR) YtD 1-year 3-year Since Jun-11 Robeco FIB 2.88% 5.82% 14.85% 10.28% Benchmark* 2.14% 5.24% 12.98% 8.30% Rel. performance 0.74% 0.58% 1.87% 1.98% Information ratio Tracking error 0.68% 0.83% 1.40% Source: Robeco. DH share class, figures gross of fees, in EUR, based on net asset value. The value of your investments may fluctuate. Returns obtained in the past are no guarantee for the future. *Benchmark: Barclays Euro-Aggregate: Corporates Financials Subordinated 2% issuer constraint (EUR). Investment Opportunity 3

4 buying bonds that have a higher average spread than that of the benchmark, such as Additional Tier 1 bonds, the new-style capital instruments that trade at relatively high spreads. The fund offers an attractive yield, i.e. 2.9% at the end of May 2015 against 2.5% for the benchmark. The core of the portfolio consists of dated Tier 2 instruments (banks and insurance debt); about 8% is invested in Additional Tier 1 bonds and another 5% in dated Tier 2 CoCos. Exposure to bonds from the European peripheral banks is limited (9% in Italy and Spain combined at the end of May 2015), and we are not invested in Portugal, Greece, Russia or China. Almost 90% of the portfolio is invested in investment grade bonds. The portfolio s average rating is BBB. Outlook: current spreads offer appealing returns The massive stimulus from the ECB quant easing program is the most important theme in the European market. This has pushed down riskfree rates and restarted the search for yield. In this environment, subordinated bonds will perform better than senior bonds. We are therefore sticking to our overweight beta target for the portfolio. We are convinced that the potential for spreads in the financial sector to contract is a long-term theme and has further to go in the next few years. The publication of the stress test results for the European banking sector in October 2014 has confirmed our view that its resilience has already improved over the past few years and we expect this to continue. Issuance of new-style instruments and issuance by banks and insurance companies that come to the market for the first time provide us with interesting opportunities. At the same time, we are not afraid that there will be a flood of new issuance, as banks have time to comply with the new rules. Improving fundamentals and attractive spreads bode well for attractive returns. Jan Willem de Moor, Portfolio Manager Portfolio positioning, Insurance Subordinated (perpetual) 9% Cash 5% Senior 1% United States 2% Other 6% Cash 5% Benelux 19% Insurance Subordinated (dated) 22% Tier 2 49% United Kingdom 18% France, Germany, Switzerland 27% Dated CoCo 4% New Style Tier 1 8% Old Style Tier 1 2% Scandinavia 12% Spain 6% Italy 3% Investment Opportunity 4

5 Most frequently used terms Term Basel III Solvency II Common Equity Tier 1 Capital (CET1) RWA Additional Tier 1 capital (AT1) Tier 1 capital Tier 2 capital Subordinated debt CoCo Source: Robeco Meaning A global regulatory framework designed to strengthen the regulation, supervision and risk management of the banking sector. Basel III regulation sets targets for higher capital buffers, better funding profiles and higher liquidity buffers. EU Directive on the amount of capital that EU insurance companies must hold to reduce the risk of insolvency. It is scheduled to come into effect on 1 January Most important part of the capital base of a bank, basically consisting of shareholders equity. To get to the amount of regulatory Common Equity Tier 1 Capital, certain items (like goodwill) are deducted from shareholders equity. To get to the CET1 ratio, the amount of CET1 Capital is divided by Risk Weighted Assets. Risk-weighted assets, i.e. all assets held by the bank weighted by credit risk. Most subordinated debt of the bank. AT1 bonds are perpetual and callable after at least 5 years. The coupon can be canceled at the bank s discretion and bonds will be written down or converted into shares at a pre-defined trigger level. Banks are expected to hold 1.5% of RWA in the form of AT1 capital. Sum of CET1 capital and AT1 capital. Tier 1 ratio is calculated by dividing Tier 1 capital by Risk Weighted Assets. Supplementary capital, consisting of certain loan loss provisions and Tier 2 bonds. Tier 2 bonds usually have maturities of 5-10 years. Coupons cannot be deferred or canceled. Banks are expected to hold 2% of RWA in the form of AT1 Capital. Debt that ranks lower than the senior debt of the bank. Contingent convertible, a convertible bond that can turn into equity if the bank faces solvency problems. It is either converted into equity, or simply written down in value if the bank s Common Equity Tier 1 drops below a certain level (trigger point), to restore the capital in the bank. Important information This publication is intended for professional investors. Robeco Institutional Asset Management B.V. (trade register number: ) has a license as manager of UCITS and AIFs from the Netherlands Authority for the Financial Markets in Amsterdam. This document is intended to provide general information on Robeco s specific capabilities, but does not constitute a recommendation or an advice to buy or sell certain securities or investment products. The prospectus and the Key Investor Information Document for the Robeco Funds can all be obtained free of charge at Investment Opportunity 5

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