Janet Wilkinson 00:09
Hello and welcome to the Partner Of Choice podcast, where we bring you the latest insights from RBC Capital Markets on equities, credit and macro markets. I'm your host, Janet Wilkinson, Managing Director and Head of Global Markets Flow Sales, EMEA. Today, we're examining a major trend shaping European financial markets, the twin rebound of bank equities and AT1 bonds. Following the turbulence of the Credit Suisse crisis, AT1s have staged a strong comeback, with record issuance and renewed investor confidence. But it's not just the AT1 market. European bank equities have also outperformed, fueled by strong fundamentals and rising profitability. So what's behind this resurgence? How should investors think about the tradeoffs between bank equities and AT1s? Where are the biggest opportunities and what risks remain as we move into 2025? So to break it all down, I'm joined by two experts from RBC Capital Markets. Firstly, Anke Reingen, Global Co-Head of Financials Research, whose deep knowledge of bank earnings, profitability, and capital strategies will help us assess the outlook for bank equities. Anke, it’s great to have you here.
Anke Reingen 01:29
Thanks. Janet, excited to be part of this discussion.
Janet Wilkinson 01:32
And we’re also joined by Marc Sánchez Roger, Head of European Financials Credit Sector Strategy, who will provide insight into the AT1 market, credit conditions, and investor sentiment in subordinated debt markets. Mark, welcome to the discussion.
Marc Sánchez Roger 01:48
Thank you for having me.
Janet Wilkinson 01:50
So let's get started. Firstly, Anke, over to you. Let's start with the recent strong performance of European bank equities. Over the past two years the sector's seen a notable rally. So what's driving this performance, and are current valuations reflecting European bank financials, or is there still room for further share price increases?
Anke Reingen 02:12
Profitability of European banks has meaningfully increased as interest rates have moved from negative low levels to where banks generally see their sweet spot. At the same time, banks have benefited from a positive capital markets environment, leading to higher income and asset and wealth management and investment banking. The other important development for European banks is that regulation is now much clearer, and there are even some suggestions it might soften. As a result, banks have been able to increase their dividends and buybacks. Since the end of last year, uncertainty has increased, especially with respect to potential tariffs. However, plans put forward for fiscal expansion in Europe have changed the dynamic for European banks to the positive again. Our economist team has recently upgraded their euro GDP expectations on the back of government spending plans. In addition, the yield curve has deepened. Both trends are positive for banks and bank stocks.
Janet Wilkinson 03:05
Superb. Thanks. Anke. So Marc, let's shift to the credit side of the market and to AT1s. What's driving the rebound in the AT1 market, and how are banks and investors responding?
Marc Sánchez Roger 03:17
So basically these instruments are a form of perpetual debt with call options at the discretion of the issuer. So that's very relevant, right? And on top of that, they feature discretionary coupon payments. The first issuances of AT1s began to appear in 2014. So it's a relatively young market, and it developed very quickly. When we look at the AT1 product, we have to bear in mind three key risks. First is the loss absorption risk, so basically writing down the instrument to zero. The second is that we have the coupon skip risk. So since coupon payments are discretionary, the issuer can decide to skip the coupon. And the third point is the duration or extension risk, so basically, the risk of skipping the call. The exceptional performance in the AT1 market can be attributed to several key factors. First of all, we've witnessed a very strong market environment, and this happened since the Fed pivot in November 2023, this famous pivoting, when both credit markets and equities showed an impressive performance. So this shift in the Fed’s monetary policy led to rate cuts, and this was combined with low default rates that created a fertile ground for credit. The second factor is that banks fundamentals are stronger than they've been in decades. If we look at banks’ balance sheets, we see very robust capital metrics, high profitability and exceptional asset quality. These factors contribute significantly to investors’ confidence in the AT1 asset class. And this leads us to the third point, the current search for yield phenomena. AT1s stand out as a particularly appealing instrument when we look on total return basis, right? Offering yields that are not only superior to many other credit asset classes, but also very, very competitive versus equities. The demand for AT1s is supported by this search for yield momentum, where investors find the combination of high quality issuers and attractive yields just irresistible. And the fourth point is that the investor base for AT1s has expanded. After a period of reduced Asian demand, let's say, just following the Credit Suisse AT1 right down back in 2023 we've seen progressively Asian investors coming back into the AT1 market, and this was obviously very supportive for the asset class. At the same time, we've seen asset managers that have been increasingly venturing into this space, diversifying the investor pool that was once mostly hedge fund territory. All this combined makes us think that AT1s will remain as one of the instruments offering a higher total return this year.
Janet Wilkinson 06:12
Thanks, Marc. So Anke, touching on Marc's use of the word irresistible, which, of course, I’m always delighted to hear. He mentioned the irresistible, strong yields on AT1s. So do these compare to bank dividend yields? And are those just as irresistible?
Anke Reingen 06:29
I would say yes. So total implied returns for European banks are really attractive. If we look just at the dividend yields for European banks, they're set at 6% on average, which is much higher than for the total European equity market at closer to 6%. But in addition to this, a number of banks buy back their shares, which would add another 4% on average to the yield. So we're looking at 10% minimum, but there are a number of banks that even offer a higher yield. For most banks, the payout ratio to shareholders is a function of earnings. So there is an element of volatility however, as profitability has structurally increased and regulatory uncertainty has declined, capital distribution should stay higher, offering attractive yields. The near-term outlook does, however, impact absolute payouts, and that creates volatility, which is admittedly different to Marc's world.
Janet Wilkinson 07:22
Thanks, Anke, so we've heard about attractive yields. We've heard about irresistible yields. Let's move on a little bit to the financing part. Marc, we've seen nearly all AT1 bonds called and refinanced as planned in the last couple of years. So what do you think this signals about the financial health of European banks and overall investor confidence?
Marc Sánchez Roger 07:44
So let me start with a brief recap of the recent AT1 issuance. In 2024, European banks have issued more than 45 billion euros in new AT1 bonds, which is a record high, which also followed over 40 billion euros issuance in 2023. But it's not just about the volume of issuance, right? If we look at 2024, we observe European banks calling their AT1s without hesitation. This is clearly a reflection of the improved European banks’ fundamentals, coupled as well with a supportive market environment. But I wanted to draw your attention to a relatively new method to manage AT1 calls, avoiding issuers to pay double carry in their AT1s. So beyond the standard method of calling AT1s at first call date, issuers have embraced a new model that consists on early refinancing these AT1s in a mechanism called tender extender. This consists in tendering an AT1 a few months in advance and taking advantage of the tight spreads to print a new AT1. Basically, as we could expect, this method has rapidly gained popularity, reflecting, again, the adaptive nature of the AT1 market that, as we just mentioned, is a very recent market, just starting in 2014. The combination of issuers calling AT1s at first call date and the tender extender method led to an increasing confidence from investors regarding the probability of AT1s being called. But here at RBC, we always prefer to show a degree of caution when we feel that the market is becoming too optimistic. And we should expect in the future, if spreads go wider, they will do eventually, to see again some non calls potentially repricing wider for those AT1 instruments with lower reset spreads. The strong financial health of European banks is well reflected across banks’ capital structure, from senior debt and covered bonds to equities and AT1s. We would expect investor sentiment to remain constructive when it comes to European banks, as we don't forecast a change in the fundamental picture anytime soon.
Janet Wilkinson 09:58
Super thanks, Marc. So clearly a strong refinancing environment, but the perpetual risk always remains for investors, and great that you highlighted that. So maybe let's move from the refinancing landscape to the regulatory landscape for the banking sector. After years of regulatory pressures, there seems to be a trend of softer regulation coming from the U.S. Do you expect Europe to follow here?
Anke Reingen 10:24
Well, we’ll see, but we were close to being finished with regulation, and then changes in the U.S. are now pushing to a softer regulation. But it's partially too late. For Europe and Switzerland the Basel III finalization came in on 1st of January, 2025. The UK has pushed the implementation to 2027 as a result of the developments in the U.S. An area of uncertainty is market risk, and the EU has made clear it wants to assure a level playing field. So if the US does not implement the rules, Europe might not do either. This will be positive for the banks with investment banking exposure. In general, there has also been an increased focus by the banks on capital optimization outside of regulation. A number of banks are highlighting securitizations and SRTs as a measure to optimize their capital base. In Switzerland, the situation is slightly different as the government is changing the resolution rules post the UBS and Credit Suisse merger. This has created a material overhang for UBS shares.
Janet Wilkinson 11:25
Thanks, Anke. And Marc, you know the question is coming your way. What's the current regulatory stance on AT1 bonds in Europe and the UK, and what major changes do you see on the horizon?
Marc Sánchez Roger 11:37
I have to say that the AT1 products have been under the spotlight for a while when it comes to regulation, with a large number of supporters, but also detractors. We saw some radical changes, right? For instance, when we look at Australia, the regulator decided to remove the AT1 asset class from the entire bank capital framework. But not all jurisdictions suffered changes. If we look at the UK and Europe, for instance, we saw a strong support from regulators to the asset class. And while we think that the AT1 instrument isn't flawless, we believe that most of the discussions that we are having involving changes in the asset class are of theoretical nature and shouldn't be a top priority for bank regulators. The AT1 fulfills its main purpose of allowing banks to develop a large layer of loss-absorbing instruments in which the regulator has the power to ask banks first to stop paying coupons, then they can block banks to redeem the instrument. And as well, they can even impose the issuer to absorb losses through their AT1s, if they consider it necessary, under a scenario of financial distress. Truth be told, we think that regulators should be relatively happy with the success of the asset class, and why not investors too, right? Because they are having a product that is yielding well above most of the alternative in the fixed income world. Looking down the road, I would say making the AT1 a product that can absorb losses on a going-concern basis is one of the priorities, right? So one idea would be potentially fine tuning the trigger mechanism. Or if you ask me, another point could be to discuss if the coupon mechanism could be changed and make AT1 coupons cumulative, for instance, that will be also a solution. Then, when we think about the timing of any potential changes in these in this regulation, we don't think that we have a legacy trade on the table as of now. With Basel 3.1 just finalized, as Anke mentioned in the previous question, and a delay in the implementation in many jurisdictions, in our opinion, we are talking about years until we see any tangible change in the AT1 asset class.
Janet Wilkinson 13:56
Thanks. And now moving on to the outlook. Anke, based on the current market environment, what is your outlook for European bank equities in 2025?
Anke Reingen 14:07
Well, the start of the year has been volatile, and we expect this to continue to be the case in the near term. The economic outlook is key, and for now, it seems that fiscal expansion will drive economic growth higher, and has also pushed long rates higher. Both are positive for bank stocks. This volatility, on the other hand, is also good for trading, but not helpful for investment bank activity. The risk on the horizon remain tariffs and a slowdown in the U.S. and global economic growth. Taking the tailwinds and headwinds together, those banks that have the potential to take somewhat control of their own outlook should do better. We think stock picking is therefore key.
Janet Wilkinson 14:47
And Marc, you know the question is coming your way now. What's your outlook on AT1 supply and performance for the rest of 2025?
Marc Sánchez Roger 14:54
We maintain our view that, despite some volatility, AT1s will outperform most asset classes in terms of total return. We expect banks to continue issuing AT1s in 2025, taking advantage of the historically tight spreads. We could see around 45 billion of Euro equivalent of AT1s being issued by European banks across major currencies, and this would be broadly aligned with 2023 and 2024 levels. Most of the new issuance, as we discussed in a previous question, will be linked to refinancings. However, there are still some banks, smaller banks, that might continue increasing their loss absorption capabilities. We are talking about medium and small peripheral banks, for instance, and some Nordic banks. So we could see new net supply coming from these banks, and that would be all in terms of supply. This year is going to show a different behavior than what we saw in 2024 because probably we would all agree that 2024 was rather a capital appreciation year, while in 2025 we expect this to be more carry or income year for the asset class. So basically, we don't see that we're going to have too much room for compression in terms of spreads from current levels, but when looking at the high coupon and the absolute yield of the asset class, we continue to see the AT1 as a very attractive product for many investors.
Janet Wilkinson 16:25
So clearly some very optimistic outlooks for both equities of European banks, and AT1s for 2025 and a lot of attractive opportunities as well. Anke, how does RBC Capital Markets support clients navigating the complexities of bank equities, and how does your research help shape client strategy?
Anke Reingen 16:47
Following up from my previous answer saying stock picking is key, I think our team can help clients with that, with our fundamental research, pick those companies that create the most value for the portfolios. But I think it's also the collaboration across the firm. In equities we spend a lot of time on forecasting earnings, predict regulation and market indicators, and therefore we work very closely with our economists, given how important GDP and rates are for us. But obviously we speak also a lot with Marc and his team. Our share prices are very closely correlated to credit. We could see this, especially in 2023 when we did a number of joint calls with investors. We are impacted by the same trends, and Marc and our team has done a number of calls on themes that impact both equity as well as credit investors. And lastly, we provide access to companies. We recently hosted our global financials conference with 147 companies attending.
Janet Wilkinson 17:46
And Marc, turning to you, how does RBC Capital Markets help clients leverage its platform to optimize their AT1 strategies?
Marc Sánchez Roger 17:55
So when it comes to credit and AT1s, here at RBC, we have a strong value chain that goes from sales and trading to strategy, DCM, solutions, Syndicate, and it's not just locally, it’s across continents and basically this places RBC in a very strong position to provide advisory and investment solutions to a broad range of clients. When looking at our trading capabilities, for example, we trade the entire bank capital structure of almost all European and global banks in euros, here in Europe, and we do their respective trading in other currencies in the other offices across the globe, from covered bonds to AT1s. And this allows us to help clients with relative value views across asset classes and specific trade ideas that will help them to benefit and to maximize their returns in their portfolios. Then, when looking at our sales force, for instance, it works together, but this is split by region, providing a bespoke coverage and helping to deliver the bonds that clients are looking for in a timely, efficient and fair manner. In sector strategy, we provide in depth market views, idea generation and as well, client support, when it comes to single name views, sector fundamentals, supplies and regulatory aspects. Then DCM, as well, is highly integrated within RBC’s value chain with daily interactions and leveraging on sales, trading and strategy to deliver the best advice and execution to issuers.
Janet Wilkinson 19:28
What a great point to end on. RBC Capital Markets being clients, partner of choice across the value chain, enabling them to optimize their performance. A huge thank you for all of your insights today into European bank equities and AT1 performance and the attractiveness and irresistibility of both of these asset classes. For our listeners we thank you for tuning into Partner Of Choice, an RBC Capital Markets podcast recorded on the 20th of March 2025 and if you enjoyed this episode, please share it with your peers.