Market Volatility and Developments in the Banking Sector

Given the ongoing volatility in the banking sector, Kim Catechis, Investment Strategist with the Franklin Templeton Institute, recently hosted a webinar with David Zahn, Co-Chair of the Stewardship and Sustainability Council and Head of Europe Fixed Income with Franklin Templeton Fixed Income, to discuss their perspective on recent events, where we are now, and what the implications are for markets in Europe and globally.

  • One week on from a shotgun marriage, credit markets seem more composed than rates

The markets appear to have largely digested the events of last week, but we now see the credit markets demonstrating more composure than the rates markets. That’s unusual, and we think it’s a strong signal from investors. We have seen that many of the spread markets are not moving as much as we would expect, excluding the AT11 (Additional Tier 1 bonds) market. It does seem that the rates markets are pricing in that we’re going to see rate cuts from the central banks, which we think is probably not appropriate. It’s really the rate volatility that is the most extreme, as opposed to say high yield or credit, which has not been nearly as punished. The rates market is trying to figure out what’s going on, whereas normally that’s a calmer market than the AT1s. It makes sense, as we did witness that big selloff of the Credit Suisse AT1 bonds last week.

  • AT1s are not dead—just reserved for the biggest and strongest

The write-down of the Credit Suisse AT1s made investors question: Is this asset class viable? Overall, we still think it’s a viable market. But it’s going to be different in the future—only the bigger banks are going to be allowed to issue AT1s. Smaller banks will likely struggle to issue their AT1s, so they may have to go back to more equity, which isn’t ideal from their perspective, but does makes sense given circumstances. We have seen a bounce back from the lows, but it is obvious that investors are still trying to get comfortable with the likely outcomes. For example, does this mean that banks will require more permanent capital as opposed to bonds that can be called? We think the process will still take some time, but the yields on AT1s are now really high, in the region of 9% to 11%. That’s the level of yields that will probably attract buyers once we see more stability.

  • The hierarchy of equity and bondholders still holds—officially

Everyone now knows that the Swiss banks (UBS and Credit Suisse) do have this clause that allows the regulatory authorities to execute a permanent write-down in the event of government involvement, just as they did in the case of Credit Suisse AT1 bondholders. All the other regulators in Europe and the United Kingdom have come out and said that they believe the equity needs to be wiped out first before the AT1s. And that’s the way it’s written in their prospectuses. This should provide some comfort, but some investors may look back and just say, well, it’s been done before, so it could happen again. In theory, anything is possible. But overall, it looks like a different market now. Investors are going to focus on the standard calculation: What is the risk versus return?