Fundamentals have improved but tariffs the cloud on the horizon
European bank equities have seen a notable rally over the past two years, underpinned by macro trends and solid improvements in the banks’ fundamentals. A normalizing of interest rates, upgraded GDP forecasts, governments’ plans for fiscal expansion, and a steepening yield curve have all contributed to equities’ performance.
“As profitability has structurally increased and regulatory uncertainty has declined, capital distribution should stay higher, offering attractive yields,” says Anke Reingen, Global Co-Head of Financials Research. However, near-term volatility linked to trade tariffs creates a level of uncertainty, she cautions. For most banks the payout to shareholders is linked to their earnings via a payout ratio target.
AT1 bond popularity rebounds
Confidence has surged back into the Additional Tier 1 (AT1) bond market too, following the enforced Credit Suisse AT1 writedown of 2023. Last year European banks issued new AT1 bonds to a record value of more than $45 billion.
The search for yield is a big driver of AT1s’ return, attracting a wide range of new investors from traditional asset managers, to private banks, into a pool previously dominated by hedge funds, says Marc Sanchez Roger, Head of European Financials Credit Sector Strategy. “AT1s stand out as a particularly appealing instrument on a total return basis,” he says. “Investors find the combination of high-quality issuers and attractive yields just irresistible.”
“AT1s stand out as a particularly appealing instrument on a total return basis – investors find the combination of high-quality issuers and attractive yields just irresistible.”
Marc Sanchez Roger, Head of European Financials Credit Sector Strategy
A disciplined approach to AT1s
AT1s come with risks, not least because the issuer retains discretion on whether to skip the call option at the end of a non-call period. Coupon payments are discretionary too. However, over the past two years, almost all European AT1 bonds have been called and refinanced as planned, with the recent exception of a large European bank announcing that it will not call an AT1 with a call date in April 2025. Confidence has been underpinned by a new ‘tender extender’ model, allows for AT1s to be tendered a few months in advance of the expected date, to take advantage of tight spreads.
While RBC expects European banks’ fundamentals and investor sentiment to remain constructive, there are some reasons to be cautious about this asset class, says Sanchez Roger. “In the future, if spreads go wider, as they eventually will, we should expect to see some AT1s potentially repricing wider, in particular those AT1s with lower reset spreads,” he says.
A rethink on regulation?
The shifting regulatory landscape may favor bank equities. After years of tightening regulatory pressures, leanings towards softer regulation in the U.S. seem set to influence Europe. This shift is a belated one for Europe – the last major reform package of Basel III came into effect in January. However, the U.K. has delayed implementation in light of U.S. developments.
Reingen says Europe may yet rethink. “The E.U. has made clear it wants to assure a level playing-field with respect to the Fundamental Review of the Trading Book, so if the U.S. does not implement the these changes, Europe might not either. This will be positive for banks with investment banking exposure,” she says.
Regulatory attitudes to AT1s also differ between territories, with Australia’s regulator phasing them out altogether. However, regulators in the U.K. and Europe are supportive, says Sanchez Roger, wielding extensive powers – they can even force banks to absorb losses through AT1s if they deem necessary.
Sanchez Roger suggests products could be further improved by fine-tuning the trigger for the loss-absorbing mechanism, or making AT1 coupons cumulative. He does not foresee new regulations for some time, though: “In many jurisdictions, we are talking about years until we see any tangible change in the AT1 asset class.”
“The E.U. has made clear it wants to assure a level playing-field on trading activities, so if the U.S. does not implement the rules, Europe might not either.”
Anke Reingen, Global Co-Head of Financials Research
Stock picking key to success
For the remainder of 2025, fiscal expansion is expected to lift economic growth and push long rates higher – both positive for bank stocks, Reingen notes. At the same time, near-term volatility might be negative for investment banking but positive for trading.
“The risk on the horizon remains tariffs and a slowdown in U.S. and global economic growth,” she adds. “Those banks with the potential to take control of their own outlook should do better – we think stock picking is therefore key.”
RBC’s team is well placed to support that process, she adds, with the equities team incorporating research by other colleagues for example in economics or credit research to forecast earnings and to predict regulatory and market indicators.
On AT1s, Sanchez Roger expects issuance to continue at broadly 2024 levels. New net supply might come from smaller banks as they continue increasing their loss absorption capabilities. “We don’t see too much room for compression in terms of spreads from current levels,” he adds. “But looking at the high coupon and the absolute yield, we continue to see the AT1 as a very attractive product for many investors.”
