Opportunities for the year ahead

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1. Why buy subordinated debt now?

2. As inflation is picking up, should investors still buy bonds?

3. If there is a risk of recession - what are the implications for European banks?

4. What's the outlook until the end of 2022?

Video transcript

1. Why buy subordinated debt now?

I think the key reason to own subordinate debt is for fixed income investors that care about capital preservation and capturing a high steady income, that's pretty much the place to be. I mean, we've been managing the strategy subordinate debt since 1985 with a compound return per annum of close to 8%. This is more than thousand percent return. But more importantly from owning investment grade issuers. And the high income we're capturing it by the enhanced income from subordination, meaning we don't have to take more credit risk, interest rate risk, or liquidity risk and have a very good predictability in term of future income.

2. As inflation is picking up, should investors still buy bonds?

Clearly in an inflationary environment, I mean the questions, I mean, should I still own bonds? And you know what we always tell investors, you need to adjust your portfolio for an inflationary environment. Not all sectors are impacted the same way, clearly. I mean, the financial sector benefits from this rising rates and are talking to the banks. We are seeing a pickup in term of net interest margin. This is good for earning, it's good for profit. Versus the corporate sector where some sectors are telling us that this inflationary environment has an impact on margin and also rising rates in term of funding costs. So the key message just in term of sectors, buying financials versus corporate is a good way to protect your portfolio against rates/inflation. Secondly, not all bonds are the same. Clearly, for the same issuer, if you own a bond which is a floater or a fixed coupn, it's not the same outcome. In our case, when I look at subordinate debt, the majority of the subordinate debt in Europe is issued with coupon called fix to floater, fix coupon for a couple of years and then becomes a floater. I think that's another way to mitigate the risk of inflation. Now, just to follow up on that, year to date, it's been a surprise in term of inflationary pressure. Central banks know about it, they have to act. That’s why the Fed is hiking, you will be expecting Fed funds above 3% by the end of the year. It means that central banks are fighting inflation at the cost of leading the economy into recession. When you talk about inflation now, it means tomorrow we will be talking about recession. It means, for your portfolio, you need to position not just for the risk of inflation, but also for the risk of recession. And so the implication is that you actually want to increase the overall credit quality of your portfolio, meaning investment grade should outperform high-yield. It was interesting with subordinate debt, the matterate of the issuers are investment-grade issuers.

3. If there is a risk of recession - what are the implications for European banks?

Keep in mind that in 2008, 2009, we had a global financial crisis. The issue back then was the financial sector had issues in term of asset quality, too much leverage, too little capital. Now, if we look in 2022, it's a completely different outcome. We are in a situation where the European financial sector has never been as strong, looking at the capital ratio, solvency ratio, liquidity ratio. And even looking at asset quality. So, if Europe were to enter into a recession, well, one of the buffers that we are benefiting from as we're talking is, because of the rising rates, we're currently seeing an increase in net interest margin. So profitability is going up. And what the sector is telling us, this increase in term of profitability should completely absorb the expected future losses should European economies enter into a recession. So once again, because of the regulatory pressure from the regulator toward the financial sector, we think that, should we enter a recession, European banks could potentially be looking like one of the most resilient sectors, because of the strong fundamentals.

4. What's the outlook until the end of 2022?

For the remainder of the year, we are very constructive. Independent of market conditions, we are going to capture the high income. I mean, right now we're capturing a yield towards of around 6%. And this is really independent on whether price go up and down. But on top of that, subordinate debt was not immune to the selloff. And so, on average, we saw some quite important price drop. I mean, we are currently down 9.5% year to date (as of recording in July 2022). Every time we experience a systemic crisis, and we tend to see some crisis every two and a half years, so this time is not different, we usually get full price recovery within six to nine months. That's a so-called ‘pull to powerful bonds’. So long story short, we are very constructive. And our best case is for double digit return for the remainder of the year. Part of that coming from income, and the remaining coming from price appreciation. Now, you know, double digit returns might sound a big number, but don't forget that 2020, we were hit by COVID. First quarter 2020, price of the bonds were down up to 20% and we finished the year in positive terms. So, we see no reason for this time to be different, hence our very constructive outlook for the remaining of the year.

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