Banks ditch Bunds for higher-yielding peripheral debt

IFR 2145 6 August to 12 August 2016
7 min read
EMEA
Gareth Gore

Ultra-low and negative yields are driving European banks to take ever-greater risks with their vast sovereign portfolios, with many selling out of their safest but low-yielding assets in order to buy riskier debt with higher returns.

Combined exposures to French, Spanish and Portuguese sovereign debt increased by €125bn in the two years running up to the latest European Banking Authority stress tests, while Chinese exposure almost doubled. At the same time, banks cut their holdings of Triple A rated German, Danish and Dutch sovereign debt.

The largest banks own more than €100bn of sovereign debt each – in part to meet strict rules that force them to hold large amounts of liquid assets – so even a small pick-up in yield can reap large increases in annual interest income.

“It’s a predictable consequence of bigger liquid assets portfolios and the natural tendency of banks to want to make a bit of money in the treasury or at least to mitigate the cost of holding the liquidity portfolio, which can be surprisingly large and material to earnings,” said Dan Davies, a senior research adviser at Frontline Analysts.

But the size of the holdings means that getting it wrong can have large repercussions. Deutsche Bank, BNP Paribas, Societe Generale and Commerzbank lost billions of euros each when their high-yielding Greek government bonds were restructured in 2011.

Banks are evidently betting that this time it’s different. Some of the biggest inflows over the two-year period have been into sovereign debt linked to countries considered to still have unsustainable fiscal situations.

France overtakes Germany

According to an IFR analysis of EBA stress test data, European banks increased their Spain exposure by 24% between the end of 2013 and the end of 2015 to €284bn, and their Portugal exposure by 143% to €21bn. France has also seen an 18% increase to overtake Germany as the biggest source of exposure at €389bn. Exposure to Chinese sovereign debt almost doubled to €32bn.

By contrast, exposure to German debt is down 9% to €382bn, to Danish debt down over a third to €12bn and to Dutch debt down 3% to €117bn. Along with Luxembourg and Sweden, they are the only European Union countries still rated AAA by S&P.

The extra yield is one attraction: Portuguese 10-year bonds have yielded an average of 240bp above their German equivalents over the past couple of years, while Spanish debt has yielded an average 130bp extra.

But commitments from the European Central Bank – both verbally from President Mario Draghi and actively in its quantitative easing purchases – to provide a supportive monetary backdrop for such countries have also lessened banks’ fears of holding such debt.

“What we’re looking at here is a poor man’s version of the old ‘EU convergence trade’”

“Now that the peripheral sovereign credit crisis is a dim memory, the banks aren’t immune to the general desire to stretch for yield,” said Davies. “What we’re looking at here is a poor man’s version of the old ‘EU convergence trade’ as the banks are betting that Draghi’s ECB won’t allow any big structural divergence or credit event.”

But the extra yield may not be the only driving force. The ECB’s €70bn-a-month bond purchases could also be making it more difficult for banks to source sufficient highly rated sovereign bonds, forcing them to instead buy second-best assets.

“I think a big factor is that banks are now competing with the ECB,” said Megan Greene, chief economist at Manulife and John Hancock Asset Management. The central bank has itself bought €954bn of government bonds, including €226bn of German debt.

Italy out of fashion

Not all peripheral names are back in vogue, though. Banks have reduced their Italian exposures by 6% to €382bn in two years. EBA data show that Intesa Sanpaolo cut exposure to its home country by €27bn, and Banca Monte dei Paschi by €10bn over the period.

Some of that shift may not necessarily reflect a discomfort with holding Italian debt. The ECB has been keen for European banks to diversify their vast sovereign debt holdings away from their home countries. Spain has become a popular trade for Italian banks.

Of the €2.6trn of net sovereign exposure held by the 51 banks in the EBA stress tests, about €1.4trn is held as available-for-sale in the banking book, about €320bn is held for trading, and €230bn as hold-to-maturity assets. There is a further €610bn of sovereign loans.

Dramatic

Fitch has recently highlighted the risk of holding sovereign bonds that have seen dramatic falls in yield in recent years. It estimates that a hypothetical rapid reversion of rates to 2011 levels for the US$37.7trn of investment-grade sovereign bonds outstanding could drive mark-to-market losses of as much as US$3.8trn.

“Potential market losses would be greatest for holders of European sovereign bonds,” it said, adding that sovereign yields for European countries – particularly Italy and Spain – have declined significantly since 2011.

However, it said that how holdings were classified could mitigate the impact of a rate rise. In addition, rate rises should benefit banks’ net interest income, and would normally only happen at a time when the economy is recovering strongly.

“For many institutional investors such as insurance companies and pension funds, a hold-to-maturity strategy mitigates market risk,” it added. “Moreover, financial institutions’ operating profiles could benefit from a rise in long-term rates, especially if such a change occurred gradually.”

Biggest holders of italian sovereign debt change in exposures from end-2013 to end-2015
Biggest holders of italian sovereign debt change in exposures from end-2013 to end-2015
HoldingsChange
UniCredit€65.3bn+€8.6bn
Intesa Sanpaolo€50.5bn–€26.8bn
Monte dei Paschi€26.2bn–€10.1bn
Banco Popolare€19.2bn+€0.8bn
Unione Di Banche€18.9bn–€0.8bn
Italiane
BNP Paribas€17.2bn–€1.8bn
Commerzbank€10.3bn–€0.5bn
BBVA€9.8bn+€6.3bn
Source: IFR/European Banking Authority
Biggest holders of spanish sovereign debt change in exposures from end-2013 to end-2015
Biggest holders of spanish sovereign debt change in exposures from end-2013 to end-2015
HoldingsChange
BBVA€65.6bn+€12.5bn
Santander€51.2bn+€10.8bn
Bankia€34.6bn–€2.9bn
Criteria Caixa€31.8bn–€8.7bn
Banco Popular€22.0bn+€11.8bn
UniCredit€15.5bn+€15.0bn
Banco de Sabadell€13.7bn–€1.7bn
BNP Paribas€6.7bn+€2.7bn
Source: IFR/European Banking Authority
Canary Wharf financial centre
Sovereign debt exposures of European banks