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Banks and finance navigate change

| December 7, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Trade wars, political pressure on the Fed and quantitative tightening all could trigger change in corporate relative value in 2019. Those considerations should enter the mix along with others shaping performance for banks and other financials, including baseline profits, asset quality and deposit costs.

Exhibit 1: Macro risks stand to shape the market in 2019

Broad credit measures remain solid among US banks & finance names

Domestic banks continue to report strong profitability and asset quality measures that are very strong across most asset classes. Strong fundamentals have been helping spreads in the bank and finance sector to tighten for the last decade, though that trend could be coming to an end. Investors have been anticipating a deterioration in credit for years, especially consumer credit. However even risky forms of credit remain stable or are improving as seen with Capital One Financial (COF) where credit card net charge-offs fell in 3Q18 to 4.15% from 4.51% the year earlier, and the delinquency rate has declined for their domestic cards. Exhibit 1 highlights how most of the top-25 domestic banks are clustered in a relationship of profitability vs cost of credit, both of which remain at very good levels. However the card companies (and ALLY) show greater variation off the mean vs banking peers, with DFS and AXP the two most profitable banks vs their cost of credit. This diversion from the mean could feed into higher volatility in spreads for such consumer finance companies.

Exhibit 1: Bank profitability versus cost of credit

Source: SNL Data, company filings and Amherst Pierpont

How important is deposit beta to bondholders?

The long-term low-rate environment built a high level of expectations among investors that the eventual increase in Fed funds rates would also bring expansion in the net interest margin (NIM) for banks. As seen in Exhibit 2, the top 25 domestic banks have seen their NIMs increase by 36 bp since bottoming-out in 2016 as assets have been repricing more quickly than liabilities for most lenders. However, that is not the case for all banks as some are more liability-sensitive and have actually seen compression in NIM.

Exhibit 2: Average NIM top 25 domestic banks

Source: SNL Data, Amherst Pierpont

For example again, COF has seen deposit funding cost rise 38 bp year-over-year, which has pushed the cost of the $221 billion interest-bearing deposits franchise to 1.11%. The rise in the cost of funding for COF has pushed NIM down 7 bp in the last twelve months (LTM). Among the SIFI banks, Citigroup has also seen margin compression with NIM 19 bp lower at 3Q18 than at the 2Q16 peer low-point and 4 bp lower than in the year-earlier period. In the 3Q18 earnings call, Citigroup management focused on “core” interest income citing a 12 bp improvement year-over-year, which means newer asset cohorts are pricing up and helping offset the low yields of legacy assets. Among the top 25 domestic banks, only four have seen NIM decline in the last twelve months: C, COF, DFS and FRC.

The big elephant in the room remains the anticipation of what quantitative tightening will bring. The loss of central bank stimulus may be to blame for the gross under-performance in all asset classes in the US in 2018. Banks will not only have to manage the risks that come with weak asset pricing, including higher loss given default and other problems, but banks will also have to manage pressures on funding as the Fed reduces its holdings of excess reserves. The money paid on excess reserves is less of a problem potentially than how to replace that asset as a component of the high-quality liquid asset (HQLA) requirements. Banks will likely be forced to buy more Treasuries, which could add to the momentum of corporate bond widening to Treasuries.

Idiosyncratic credit risks that could imperil the market

The outcome for GE bondholders will take a long time to unfold and we remain very negative on credit exposure to the name beyond the bank lines (2022 maturities or shorter). Investors should avoid the GE 5.00% perpetuals even at the current levels of $76, which is close to the $73 low. The higher current yield is not enough to counterbalance the risk of how to exit a position at some time in the future without taking a loss. Chances that those notes get called in 2019 or any time close to that are low, but the risk of coupon suspension is also low given the low cost of debt servicing for GE and the need to keep those investors happy as they are largely the same investors that buy the unsecured debt. Cash coming in from pending asset sales and free cash flow will be sufficient to service debt into the 2022 time frame. What remains a risk is how well GE spins the HC unit and how committed the company is to using those proceeds and the proceeds from selling Baker Hughes shares for further deleveraging. Finally, with SEC investigations in progress and risks in the power division, we take a skeptical view on the profitability of the remaining business at GE, which will effectively be limited to the aviation business. Will that be enough to service the adjusted debt load after HC and BHGE are no longer there? And how will the ratings agencies treat the smaller, perhaps higher-levered GE? This melt-down could have a negative impact on how retail investors view the market.

Before pinpointing the next great short ideas, let’s discuss what is safe: domestic SIFI banks. The SIFI banks and large regional banks have crested very high capital ratios and low criticized asset levels to the benefit of bondholders and the equity markets alike. The regulatory rules from the Dodd-Frank legislation along with more uniform international standards in Basel III have made the large banks far more immune from real harm in troubled times. In fact, with nearly twice the capital of prior era and the more important liquidity standards now, banks are highly insulated from most foreseeable events.

If we take SIFI out of the risk equation, then where could problems occur? The levered loan market grows more concerning with a large amount of “covenant lite” debt having been issued already. These covenant lite loans were forged in the fires of high investor demand in a low-rate environment, which is to blame for the mispricing of risk. The outcome in times with mispriced risk tends to be unfavorable, particularly for lenders, which will be banks, bondholders, or the growing universe of private debt lenders.

Capital structure arbitrage: are bank preferreds coming back?

There have been few safe places to hide in recent months in the corporate bond market and the domestic bank preferred securities class especially hard-hit. With more notes trading at a discount to par now than in any time since February 2016, the question is: which additional tier 1 (AT1) perps have positive near-term value?

We think there is value in select areas among AT1 notes. For example among recent Yankee issuances, the UBS 5.00% NC23 CoCo notes were issued in mid-Jan ’18 and now trade in the $82.50 area, or yield to call of 10.1% and 6.33% on perpetual basis. Given the low reset level of 5-year swaps +243.2 bp, that leaves the notes exposed to considerable extension risk, though the low dollar price makes them appealing from a limited downside benefit, which is also supported by a current yield of 6.07%. Another cheap Yankee AT1 issued this year is the SOCGEN 6.75% NC28 that currently trades at $85.00 with a yield to call of 9.18% and a yield to maturity of 8.04% (current yield right at 8.0% as well). What’s more, with a back-end reset of 5-year swaps +392.9 bp we see materially lower extension risk for the SOCGEN notes vis-à-vis the UBS or other recent AT1 issues.

Among the domestic AT1 we favor, we continue to prefer the near-term callable notes, especially those with floating reset levels of +325 bp or higher. The former JPM 7.90% notes (3mL+347 bp floater now) was originally a $6 billion issue, but JPM is gradually reducing that, which now stands at $4.3 billion. Remarkably these notes trade just below par despite a 5.99% current coupon and what seems like a short life ahead of it. Citigroup has a spotty recent history with its preferred securities (conversion to common in the crisis), and in more recent years a heavy negative technical vs peers. The latter point actually benefited investors as coupons paid by Citi were high, and extension risk thereby low given the high floating reset rates. The first callable date for Citi among its preferreds is the C 5.80% callable in Nov ’19; these notes currently price just above par and have a yield to call of 5.5% and a lofty reset of 409.3 bp. This leaves little doubt that the notes will be called and refinanced, if not on the first call date, then at a point soon after that fits with the Fed’s comfort level. With a floating reset that high, bondholders would only benefit from an extension as the yield to maturity is currently 6.93%.

Summary of pics and pans

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