European Banks—Choosing the Right Layer of the Capital Structure

European Banks have mostly been magnets for bad news and disappointment for their equity holders. But we believe other parts of the banks’ capital structure offer solid returns, backed by resilient balance sheets.

The Problem? Poor Profitability, Not Weak Balance Sheets

European banks have been struggling to improve profitability in a persistently tough environment. Continuous low rates, a flat yield curve and low regional economic growth have proved to be a toxic trifecta for their earnings. On top of that, equity shareholders have faced a continuing stream of governance lapses and potential litigation. It’s little wonder that European bank stocks have performed badly—both compared with the wider stock market and in absolute terms—over the last few years.

On the other hand, European bank bonds have generally performed well. In particular, contingent convertible securities (CoCos)—including Additional Tier 1 (AT1) CoCos—have delivered robust returns, driven by stronger and more liquid bank balance sheets, with higher capital and better asset quality. The result has been a divergence in performance, with AT1s outperforming banks’ stocks by almost 50% over the last five years, and a lower correlation between banks’ bonds and equity (Displays, below).

Over this period, AT1 prices have also been relatively stable, with volatility ranging between just 6-8%—compared to equity volatility averaging around 25%.*  

Choosing the Right Exposures to Banks for the Future

There are several reasons why, going forward, we think AT1s offer an attractive opportunity for European investors.