1. Bond Beats –
    A Bird in the Hand

    Credit Team. November 2019
  2. The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.

  3. We all love a bargain, right? In fact, we love them so much that when that big, bold, bright ‘25% off’ sticker catches our eye it’s nigh on impossible not to get suckered into buying something you didn’t even want or need. We might regret the purchase later, but we are like moths to a flame, every time.

    Well, if you let your eye wander to European bank equities you might find yourself reaching for your wallet. The price to book ratio*, shown in the chart below, is commonly used to measure the value of a bank’s stock. Right now, this ratio is not indicating a measly 25 per cent discount, it’s suggesting you could pick up European bank stocks at a whopping 40 per cent off their theoretical ‘fair’ value!


    Price-to-book value for the EURO STOXX Bank Index


    Source: Baillie Gifford & Co, Bloomberg. Data to at October 21, 2019, in local currency.

    *Price to book (P/B) – a measure of value. A P/B of 1 is theoretically fair value. A P/B of more than 1 means the stock is trading at a premium, suggesting the prospect of high returns/dividends to come. A P/B lower than 1 suggests lack of confidence in profitability or that there are losses to come which have not yet been realised e.g. provisioning or write down of intangible assets such as good will.


    Moreover, banks have now had more than a decade to simplify, refocus and repair their balance sheets. This passage of time has also allowed many of the post global financial crisis headwinds for bank profitability to ease (e.g. litigation, bad loan and restructuring costs).

    Could we be primed for a share price recovery?

    On the plus side, Europe is not in recession and the central banks continue to provide support in the form of cheap funding. Ongoing digitalisation and technological enhancements are structurally reducing bank’s cost base (less staff and smaller branch footprint), and the tower of bad loans resulting from the crisis has been significantly lowered through recoveries and write-offs.

    The problem is that banks traditionally generate much of their income through the interest rate margin. Effectively, that’s the difference between what they pay to borrow (e.g. the interest they pay for deposits) and what they charge to lend (e.g. the interest they charge for mortgages). Right now, Europe is in a low growth, low inflation, low interest rate environment, which puts a heavy strain on banks’ ability to generate this type of revenue.

    Why? Well, low growth coupled with already reasonably high levels of debt dampens the appetite of both individuals and companies to borrow, thus limiting banks’ ability to generate income through volume growth. Not only are global interest rates at, or near, all-time lows, greater than $15 trillion (yes, trillion) of global debt now carries a negative interest rate. That means lenders actually pay the borrower for the pleasure to lend to them! This low rate environment means the interest margin banks can capture has been, and continues to be, crushed. As such, earnings generation relative to pre-crisis is significantly subdued. Only time will tell if these pressures are structural or cyclical, but importantly, they seem unlikely to dissipate anytime soon.

    What’s more, the regulators continue to raise the amount of equity that banks need to hold to operate safely. This excess equity acts as a cushion to absorb losses in a downturn, thus reducing the risk of future tax payer bailouts. In simple terms, more equity means that any profit generated is diluted by a larger ownership base.

    So, banks are being squeezed on both sides, income is harder to come by, and what is made is then spread more thinly.

    In fact, if you compare the situation in Europe to Japan, where the macro environment has been stagnating for longer, you might decide that European bank share prices have further to fall. While European banks are trading at 40 per cent discount to their book value, Japanese banks are at a massive 60 per cent discount to their book value! The point is, optically cheap assets can continue to get cheaper. Perhaps we need to rethink what ‘fair value’ is in this lower for(ever) longer interest rate environment.

    But wait, it’s not all doom and gloom! This doesn’t mean European banks are a bad investment full stop. There are other ways to capture value, beyond equity.

    Deeply subordinated capital is a niche market more commonly referred to as the CoCo market. These securities, born out of the financial crisis, are akin to an insurance policy for banks. The concept being that the banks pay CoCo owners (i.e. investors) relatively high levels of income (like an insurance premium), and in return, if the bank faces collapse, the insurance claim is made, and CoCo owners most likely lose all their investment.

    “Why would I want to own something that risks losing all my investment?”, I hear you ask. Well, you might just as easily ask yourself “Why fly in an aeroplane given that the chance of survival, should something go wrong, is close to zero?” The reality is it’s statistically the safest way to travel and, importantly, you wouldn’t choose to board a plane if it had a wing hanging off!

    European banks, broadly speaking, might be struggling to generate enough return to please their shareholders, but they are fundamentally on solid ground from a credit (i.e. lenders) perspective.

    Still not convinced? Look at the chart below. The purple line shows the total return profile of European bank equity from end 2016, when valuations (e.g. price to book) and profitability (e.g. return on equity) metrics were at similar levels as they are today. Investors caught by the lure of potential high equity returns instead have seen massive value destruction. The blue line tracks Euro denominated CoCos, demonstrating the power of capturing and reinvesting a high level of reliable income (the insurance premiums we talked about).


    Total Return of European Bank Equity and Euro denominated CoCos since 2016


    Source: Baillie Gifford & Co, Bloomberg. Data from 30 December 2016 to 21 October 2019, in local currency.
    Data rebased to 100.


    As the banks continue their recovery, regulators will continue to prioritise financial stability over high levels of bank profitability. As such, the direction of bank equity prices is difficult to predict with any confidence. However, we see this point in the cycle as a sweet spot for investing selectively in CoCo structures of strong banks and have been gradually increasing our investments to help generate attractive long-term performance for our clients.

    The power of compounding high levels of reliable income over time can generate strong long-term returns for actual investors, and is, at times, more prudent than seeking higher potential, less certain outcomes. As the old adage goes, a bird in the hand is worth two in the bush.


    "Compound Interest is the eighth wonder of the world. He who understands it, earns it... he who doesn't pays it."

    Albert Einstein


    © Hulton Archive/Getty Images


    Annual Past Performance to 30 September Each Year (%)







    EURO STOXX Bank Index






    Markit Iboxx EUR Contingent Convertible Liquid Developed Market AT1 Index.






    Source: Stoxx, iBoxx. Euros.

    Past performance is not a guide to future results.

  4. Important Information & Risk Factors

    The views expressed in this blog should not be considered as advice or a recommendation to buy, sell or hold a particular investment and it does not in any way constitute investment advice.

    This communication was produced and approved on the stated date and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

    The value of an investment in the fund, and any income from it, can fall as well as rise and investors may not get back the amount invested. Bonds issued by companies and governments may be adversely affected by changes in interest rates, expectations of inflation and a decline in the creditworthiness of the bond issuer. The issuers of bonds in which the fund invests may not be able to pay the bond income as promised or could fail to repay the capital amount.

    Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions. This blog contains information on investments which does not constitute independent investment research. Accordingly, it is not subject to the protections afforded to independent research and Baillie Gifford and its staff may have dealt in the investments concerned.

    The index data referenced herein is the property of one or more third party index provider(s) and is used under license. Such index providers accept no liability in connection with this document. For full details, see www.bailliegifford.com/legal

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