La Française: Annual commentary on subordinated debt

22 januari 2025

2024 was an excellent year for subordinated debt, with positive performances across all sub-asset classes, and in particular on Additional Tier 1 (AT1) CoCos denominated in EUR, which ended the year at +13.6%, clearly outperforming their USD counterparts (+10.5%) which, for their part, underperformed significantly from mid-October due to increased decoupling between eurozone and U.S. interest rate markets ahead of Donald Trump’s election.

European AT1 spreads denominated in USD approached their historic lows, finishing the year at 284 bps of OAS (down from 415 bps at the start of the year), while AT1 EUR spreads stood at 343 bps (down from 517 bps). This performance is particularly noteworthy given the resurgence of concerns over U.S. commercial real estate during the first two months of the year. These concerns led to a sharp decline in U.S. bank NY Community Bancorp and, by extension, German banks Deutsche Pfandbriefbank and Aareal Bank, both highly exposed to commercial real estate markets. However, valuations gradually normalized over the course of the year. Corporate Hybrids also performed strongly, finishing the year at +7.5%, close to the +7.6% return of subordinated insurance debt denominated in EUR.

The strong performance was the result of significant carry levels in early 2024, a decline of interest rates in the Eurozone and a significant spread compression. The strong appetite for yield was visible for most of the year, with steady and substantial inflows into credit funds overall, as investors sought comfortable bond yields, in a less buoyant macroeconomic environment with falling inflation targets.

AT1 CoCos had a year marked by record levels of primary issues aimed at pre-financing early redemption periods for securities scheduled in 2024 and H1 2025. A paradigm shift has taken place this year, with new issuances accompanied by early calls on existing securities, allowing for a significant normalization of the AT1 yield curve, which was inverted at the start of 2024. As a result, investor concerns about future calls eased, and issuers no longer had to pay double interest charges during the overlap of new and called securities. We do not anticipate any major changes to AT1 regulation in 2025, despite the Australian regulator's decision to phase out AT1 in the capital structure of local banks from 2027, a move we believe is unlikely to be adopted more broadly.

In terms of bond structuring, we can see an increasing complexity and sophistication in the Corporate Hybrids segment (subordinated issues by corporates outside the banking and insurance sectors). Moody’s revised its rating methodology, allowing issuers to place Hybrid debts with maturities of 30 years, an initial call date of at least five years, and a requirement to repay any deferred cumulative coupons within 5–10 years. Under this framework, bonds can be rated just one notch below the senior debt of an issuer, as long as there are no other hybrid instruments following S&P's criteria or if these hybrids are explicitly subordinated under Moody’s methodology.

If both types of hybrid instruments are present, the bond is rated two notches below senior debt (as S&P typically does) and is on equal footing (pari passu) with other "classic" hybrid debts, as long as those other instruments exist. This extra layer of potential subordination is becoming more common among issuers, with both types of instruments now often coexisting.

The biggest theme for the financial sector in 2024 was the return of M&A activity, focused on size and market share. On the banking side, the second half of the year saw ongoing negotiations between UniCredit and Commerzbank, then between UniCredit and Banco BPM, causing the reaction of Crédit Agricole (shareholder of Banco BPM), while on their side, Banco BPM also strengthened its position by launching a takeover bid for Anima and increasing its stake in Banca Monte dei Paschi di Siena.

We have commented regularly on the ongoing negotiations, involving several banks and whose outcome is still very uncertain. In Spain, BBVA is still waiting to see if its takeover bid for Banco Sabadell will be accepted and if so, under what conditions. In the United Kingdom, the mergers between Nationwide and Virgin Money, and Coventry Building Society and Co op Bank were validated by UK regulators. Finally, Danish bank Nykredit announced in December that it was acquiring Spar Nord Bank to form Denmark's third largest bank.

On the insurance side, BNP Paribas Cardif is expected to integrate with AXA IM's asset management businesses and Aviva will acquire Direct Line in the UK. This consolidation trend is likely to continue into 2025, with a potential agreement between Generali and Natixis regarding their asset management activities.