Bank Tier 2s: It pays to be selective within bank credit

September 2, 2024

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While bank Tier 2 debt has performed well over the last 12 months, is there any value left, or is there more to it?

Banks have been one of our top picks within European investment grade (IG) credit for over a decade. We believe the sector offers attractive valuations relative to the wider market (Figure 1) and has continued to strengthen fundamentally over recent years.

Subordinated versus senior

Bank capital stacks contain different types of debt: perpetual, junior subordinated AT1s, dated subordinated Tier 2s as well as different types of senior debt. As global institutions, banks also issue in multiple currencies. These features give us the opportunity to position based on relative value within capital stacks and take advantage of the more attractively priced instruments.

In our portfolios we have been positioned with a preference for Tier 2s relative to seniors, and this has worked well over the last year. Subordinated financial spreads have tightened by around 70bps at the index level, while senior financials spreads tightened by c.40bps, reducing the difference between subordinated and seniors (the sub-senior differential) from over 100bps to around 70bps (Figure 2).

We actively monitor the sub-senior differential as one indicator of whether Tier 2s are under, over, or fairly valued versus seniors. At c.70bps, this differential is below the 5-year average. Put into context, the differential remains comfortably above the lows of around 50bps during the ultra-low rates era in September 2022, but far below the peak of 120bps hit during the banking sector turmoil in the US and Switzerland in March 2023.

There are fundamental arguments which justify a below-average differential. Solvency and liquidity ratios remain elevated, return on equity ratios are on average above 10% in the Euro area,¹ and EU and UK banks weathered the banking failures in the US and Switzerland well last year.

But this tightness raises the question of whether Tier 2s are becoming more expensive. However, index data only tells part of the story.

Hidden value in shorter-dated bonds

Digging deeper, we notice two trends:

1. European bank credit curves are as varied as the banks that issue them. This means some Tier 2s screen cheaper vs. seniors at the issuer level, and some more expensive.
2. There is a noticeable variance by duration. Looking at the sub-senior differentials of individual bond pairs issued by European banks, it is clear investors are paid a greater premium over seniors for owning shorter-dated Tier 2s, specifically Tier 2 bonds callable within 1-3 years (Figure 3). While there is some variance within capital stacks, as a general guide it highlights the relative cheapness to seniors of short-dated Tier 2.

In Figure 3, each data point shows the difference in yields between IG Tier 2 and IG non-preferred/holding company senior bonds of the same issuer, which have a first call date within 0.4 years of one another, plotted against the years to first call of the Tier 2 bond.

In our view, the risk that Tier 2 bonds are not called at the first call date is low. This is due to the economics of the call option, which is linked to a gradual loss in regulatory value, and issuer behaviour. In our portfolios we are mindful of picking Tier 2s we believe will be called at the first call date.

In summary, we see continued value in European bank credit over the broader corporate market. Within the sector, we have seen a steady compression of senior-sub spread premia (something recently covered in our August Close Up).

However, we also believe spread premia remain most attractive among the shortest-dated Tier 2s, which particularly suit short-duration portfolios. In our view, these instruments offer some of the most attractive yields in the European IG market thanks to the continued inversion of rate curves. They also capture some of the widest senior-sub spread differentials, and should reduce portfolio volatility by keeping duration low in these subordinated instruments.

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of August 2024 and may change without notice.

References

1.European Banking Authority, Q1 2024. Risk dashboard.

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Index Descriptions

EB00 - The ICE BofA Euro Financial Index tracks the performance of EUR denominated investment grade debt publicly issued by financial institutions in the eurobond or Euro member domestic markets.

EN00 - The ICE BofA Euro Non-Financial Index tracks the performance of non-financial EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets.

EBSU – The ICE BofA Subordinated Financial Index is a subset of ICE BofA Euro Financial Index including all subordinated securities.

EBXS – The ICE BofA Unsubordinated Euro Financial Index is a subset of ICE BofA Euro Financial Index excluding all subordinated securities.

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