Groupama Axiom Legacy 21 is a fund invested in financial subordinated debt and covers all the various types of “legacy” subordinated debt issued before the creation of Additional Tier 1 (AT1) securities.
Groupama Axiom Legacy 21 will aim to obtain an annualized yield greater than or equal to the 3-month Euribor rate +3% (after deduction of management costs) over a recommended minimum investment period of 4 years.
“Legacy” subordinate debt refers to all the subordinated debt instruments issued by banks under the Basel I and Basel II Accords and therefore being phased out of regulatory capital up to 2021. This investment universe still contains 165 billion euros in securities, compared to 150 billion for AT1.
The management strategy of the fund is based on the historic transition that is currently under way in the European banking sector towards a new cycle (change of economic models and more favourable interest rates) and a new regulatory environment, with the entry into force of Basel III. To recap, the Basel Committee stipulated a transition period ending in 2021 for the changeover from Basel II to Basel III, before the new capital requirements of the CET1 ratio(2) (Common Equity Tier 1) enter into force.
In this context, Groupama Asset Management is launching the Groupama Axiom Legacy 21 fund and delegating the financial management of the fund to Axiom-AI, a company with recognized ‘expertise in the financial sector, and more specifically in this asset class.
The portfolio will consist of a majority of subordinated debt issued by European banks and insurance companies, together with preferred shares (3).
It will be structured into four types of instrument:
Securities discounted by the markets, i.e. orphan instruments which will lose their eligibility as regulatory capital over the course of the transition period and that offer possibilities for capital gains with the call or buyback offer from the issuer;
“Fixed to fixed” securities, which have the specific feature of having fixed coupons combined with moderate volatility and which can take the form of preferred shares,
“Long call” options, with a first call date after the end of the transition period: these instruments offer attractive potential yield and capital gains when the issuer offers to buy back the stock.
Securities issued by financial establishments that are currently improving their credit position, with a resulting potential for appreciation in the price of their bonds.
“The universe of these “legacy” securities is vast. However, investors have been relatively shy of entering it, in view of the diversity of instruments and, sometimes, the difficulty of estimating their residual life as regulatory capital. According to our analysis, these subordinated debts have a good historic position and offer an attractive risk/reward trade-off,” comments David Benamou, portfolios’ manager of the fund, and Chief Investment Officer at Axiom-AI.
European banking sector in much better health
Since 2009, the financial situation of the European banking sector has considerably improved, especially in terms of equity. The average Tier 1 common capital ratio (CET1 – Common Equity Tier 1) of the European banks is now above 15%, or 2 times higher than in 2007(Source: Axiom Alternative Investments – data as of 31/12/2016).
The year 2016 was marked by an overall return to profitability of the sector (with profits of 23.5 billion euros for French banks – source: Axiom Alternative Investments), and some banks are now returning to their historic peak levels. This healthy performance of the sector has been confirmed in 2017, with the results for the first quarter exceeding the expectations of analysts for the third consecutive quarter.
“At the regulatory level, the establishment of the EU banking union and the Single Supervisory Mechanism provides investors with a more harmonized regulatory and financial framework,” explains Thierry Goudin, Development Manager of Groupama AM.
A regulatory transition that offers new opportunities
At the same time, new mandatory equity requirements have progressively taken effect. The Basel III Accord requires banks to hold more capital and specifies a new format for subordinated debt (“Additional Tier 1” – AT1) to replace the previous instruments (“Legacy” subordinated debt).
A transition period allows banks to progressively replace their old legacy bonds with AT1 by December 2021.
Main risks of the portfolio
The portfolio is exposed to the following risks: capital loss risks, interest rate risk, credit risk, risk intrinsic to the use of speculative (high-yield) instruments, risks specific to convertible bonds, forward commitment risks, risks of investing in AT1 bonds or “contingent convertible bonds” (CoCos), counterparty and liquidity risks, risks relating to securities financing transactions and financial guarantee management, risks of sectoral concentration of the portfolio, risks inherent to discretionary investment management and risks of the equity and foreign exchange markets.
(1 )Additional Tier 1: new format for subordinated debt eligible as regulatory capital under Basel III, both for the solvency ratio and (partially) for the leverage ratio. The coupons are discretionary, and the face value can be reduced either by conversion into equity (“contingent convertible bonds” or “CoCos”) or by a face value reduction that can subsequently be restored.
(2) Common Equity Tier 1: Under Basel III, “Common Equity Tier 1” is the most reliable form of regulatory capital, comprising primarily the core capital (including equity) and undistributed reserves, with certain deductions from the capital reported in the financial accounts (such as deferred tax assets). The CET1 ratio is the ratio between the Common Equity Tier 1 capital and the RWA (risk-weighted assets). Therefore, CET1 does not include subordinated debt.
(3) The UCITS will be able to invest up to 50% of its net assets in preferred shares and up to 10% in conventional equity.