For European banks’ stockholders, 2020 was a year to forget. But bank bondholders enjoyed positive returns and may overcome COVID-19 challenges again in 2021, backed by solid balance sheets and supportive regulatory conditions.

The impact of the coronavirus has piled further pressure on European bank equity. Already struggling with weak growth and low interest rates, COVID-19 triggered further loan loss provisions, smaller profits and constraints on dividends. Yet some of those factors have improved the position of bank bondholders, for several reasons.

Balance Sheets Strengthen Going Into 2021

Banks are mostly entering 2021 in a relatively strong position. In 2020 they were typically able to reinforce already strong balance sheets in two ways.

Firstly, restrictions on dividend payouts and share buybacks in 2020 by the European Central Bank (ECB) and Bank of England (BoE) prevented banks from distributing capital. While dividend payouts will be permitted in 2021, they likely will be capped to a small percentage of profits.

Secondly, regulators gave banks substantial latitude to maintain lending to businesses without incurring supervisory interventions. This “regulatory forbearance” helps banks grow their assets without incurring a penalty through higher capital requirements.

Bank liquidity is relatively high too (Display, below). During the crisis, customers have been spending less and saving more. The ECB has helped with cheap funding as well, by extending its targeted longer-term refinancing operations (TLTRO) aimed at supporting the euro-area economy. And aside from government-supported lending, loan growth has generally lagged deposit growth—so excess deposits have been recycled as liquid assets.

Asset Quality May Fall—but from a High Level

Many businesses across the eurozone are still facing a tough year. The main risk is that they may struggle to service their debt if government and central bank support ends during 2021. In this scenario unemployment would likely rise, and default rates would increase for small to medium enterprises, especially in hard-hit sectors like hospitality, tourism and retail. Ultimately, the banking sector would be negatively affected by a deterioration in loan defaults.

But even if this erodes the quality of banks’ loan books, their starting point is solid. Nonperforming loans (NPLs) are at historically low levels and provisions for potential losses have been increased. Crucially for investors in banks’ Additional Tier 1 bonds (AT1s) contingent convertible debt (CoCos), our research suggests that most banks now have enough capital to absorb potential losses—well above provisioning levels—without triggering the conversion to equity or write-off.