Time to look at bank bonds?

The value and income from a fund’s assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. Where any performance is mentioned, please note that past performance is not a guide to future performance. 

Banks are currently one of our favoured areas within global fixed income markets, as we believe the sector offers resilient fundamentals and compelling valuations. We believe that banks today are in a much better shape than in 2008, being strongly capitalised and well placed to withstand a recessionary environment. Banks also generally benefit from higher interest rates, since they are able to capture a wider spread between their lending and deposit rates. Despite these positive factors, banks currently trade at a significant discount to other sectors having sold off sharply in 2022. We are finding especially good value in the primary market where we are currently seeing an attractive new issue premium amongst many high‐quality banking names. 

Robust fundamentals

From a fundamental perspective, we believe banks are in a much stronger position than in 2008. While banks would clearly not be immune to a severe economic downturn, we believe the sector is managed in a much more prudent manner than was previously the case and should be able to withstand a more recessionary environment. 

In stark contrast to 2008, US banks today are both highly liquid and well‐capitalised. Deposits now represent more than 90% of liabilities, compared to around 75% before the financial crisis. Highly liquid assets (ie, cash, treasuries and agency bonds) make up around 35% of total assets, compared to a pre‐2008 range of around 15‐20% (see Figure 1).    

It is a similar story in Europe, where asset quality and underwriting standards have greatly improved over the past decade. According to the European Central Bank, non‐performing loan ratios have declined from 8% in 2015 to less than 2% today. Common Equity Tier 1 (CET1) ratios – which measure a bank’s core equity capital versus its total risk‐weighted assets – are today in the 12‐14% range. This is comfortably in excess of the minimum Basel III requirements of 7% and suggests that European banks have a significant buffer to withstand financial stress and maintain solvency.

Banks have also been benefiting from the current higher interest rate environment, as they are able to capture higher net interest margins on their lending activity. We believe this should provide a meaningful uplift to bank revenues, helping to partly offset losses which may arise from an increase in bad loans as the global economy slows. 

Another factor that we would expect to boost bank profitability is the continued shift towards digital banking. As increasing numbers of customers migrate to digital channels, banks should be able to reduce their number of physical branches, which in turn should help to significantly reduce their fixed costs.

Figure 1. US banks are highly liquid and well‐capitalised

Compelling valuations

While the probability of a global recession has increased, the magnitude of the recession is still very much up for debate. Our view is that we are starting from a much stronger position than in 2008 – both household and company balance sheets are in decent shape and the economy as a whole contains far less leverage. As a result, we are not expecting corporate defaults to increase to the levels currently priced in by markets and we believe corporate bond investors are being well paid to take credit risk.   

This is particularly the case within the banking sector, which we think appears cheap not only in absolute terms, but also in relative terms. For instance, European financials offer a meaningful spread pick‐up versus industrials across all maturities (see Figure 2).

Figure 2. Financials appear cheap versus non‐financials

A constructive outlook for banks

Given their strong fundamentals and compelling valuations, we remain constructive on banks. However, it is important to be selective in this area, and we generally favour the larger national banks with resilient balance sheets and a dominant market position. Other key qualities we look for include strong capital buffers, diversified sources of funding and a good track record of managing risk throughout the economic cycle. Given the current inflation situation, we also prefer banks that are less exposed to consumers in lower income cohorts, which tend to be most heavily impacted by rising inflation and energy prices. From a regional perspective, we generally have a preference towards euro‐denominated issues, primarily on valuation grounds. 

Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the portfolio. High yield bonds usually carry greater risk that the bond issuers may not be able to pay interest or return the capital.