Exceeding Expectations in the First Three years

What You Need to Know

Investing in banks’ subordinated debt such as Additional Tier 1 (also known as CoCos1) has entered the mainstream—but it comes with some specific risks. AllianceBernstein’s (AB’s) Financial Credit Portfolio (the Fund) has outperformed its benchmark, as well as other relevant indices and peers in this relatively complex asset class. Portfolio Managers Jørgen Kjærsgaard and Steve Hussey and Quantitative Research Analyst Sahil Khan discuss the unique characteristics that have helped the Fund capture the most upside risk while avoiding the pitfalls during its first three years.

Q. How has the Fund performed since its inception?

Steve Hussey (SH): In its first three years, the Fund returned 31.9% cumulative net of fees.2 This compared to a three-month LIBOR benchmark return of 5.2%.

The Fund also finished ahead of the three most relevant indexes: the Bloomberg Barclays Global CoCo Financial Institutions Index—US dollar-hedged (which returned 28.6%); the Bloomberg Barclays AT1 Index—US–dollar–hedged (29.1%); and the Bank of America Merrill Lynch Contingent Capital Index (26.0%). Over the same period, the Fund outperformed notable names with similar funds such as PIMCO (23.2%), Algebris (30.4%) and BlueBay (31.0%).3 So Fund performance in both absolute and relative terms has been outstanding. It’s a measure of the Fund’s very high returns that, in the wide-ranging Morningstar EAA Fund Other Bond category comprising 604 bond funds with a three-year track record, the Fund ranked number two over this period. (The number one fund invested principally in Greek government and other Greek bonds, illustrating the very extensive range of mandates in this peer group.)

Q. What has made the Fund so successful—and is that success repeatable?

Jørgen Kjærsgaard (JK): First, we select from a global opportunity set across all financials and across each issuer’s capital structure. That enables us to capture opportunities wherever and however they arise. For instance, in the first three years, a large part of the Fund’s performance has come from European AT1s, but we have also been able to add value through investing in US preference shares, emerging market AT1s, and insurance and bank Tier 2 debt.

Second, we have a highly experienced global team with a long track record of investing in legacy Tier 1 (since the late 1990s) and AT1s (since they were first issued in 2013), and we have a dedicated group within our fixed-income team focused on financials. This includes four specialist traders and one quantitative analyst, plus four financial credit analysts based in New York, London and Hong Kong. Their local expertise is vital for us to fully understand the range of global opportunities.

Although the complexity of AT1s provides a great opportunity to add value, it takes real experience and insight to assess each security comprehensively. It’s the quality of our team that gives me confidence that we have done our due diligence thoroughly, that we know the credits inside out and that we have spotted any red flags or warning signs when they appear.

Third, we focus on taking concentrated positions in high-quality issuers. This Fund is intrinsically a higher-risk strategy, and that’s why we’ve been able to generate great returns. We generally concentrate on higher-quality names because we believe they offer the most consistent pay-offs, although we do buy smaller, secondary names when relative value looks compelling. Nevertheless, these still need to offer robust capital buffers against loss, and so we generally avoid the much smaller, fragile CCC-rated names.

And fourth, because we have high confidence in our analysis and price targets, we have run with a fairly concentrated portfolio and have been quite nimble in terms of entering and exiting positions. This dynamic approach has been a key driver of consistent performance during the extremes of the pre- and post-pandemic environment (Display, below). AB’s proprietary trading technology (ALFA) has also been important in helping us source liquidity and trade efficiently.

Fifth and last, we apply both in-depth fundamental and quantitative (quant) research—an approach we call “dual advocacy.” We then apportion relatively higher weightings to what we consider the best structure and currency bond for each issuer. Including a security in the portfolio is the result of extensive daily discussion between me and the broader PM team, Steve (and his global team of fundamental analysts) and Sahil, with input from our dedicated financial traders globally. Given the complexity of AT1s, we have developed a dedicated quant AT1 model that allows us to determine relative value across and within AT1 issuers, and this gives us valuable insights into the overall tone of the AT1 market.

Since the inception of the Fund, we still have the same team and the same process, and our trading technology is constantly improving, so we have high conviction that we can repeat our success consistently in future.

Why is quant particularly valuable for AT1s?

Sahil Khan (SK): AT1s are complex securities with credit, equity and volatility features that mean they can behave in very different ways depending on market conditions. It is therefore vital to understand how to appropriately price the different features and determine a fair value for these instruments and attribute what is driving their performance. Our model allows us to create surfaces that price these instruments across moves in spreads, equity and volatility, and therefore far better identify how the various types of negative convexity affect these assets. But even the best quant model has limitations. Each issuing bank is different, and each AT1 issue may have very specific features that can make a difference to its fair value. That’s why we need our fundamental analysts to research the small print in the terms of each bond, and to understand the nuances of accounting and regulation across different countries. The dual advocacy approach is key to our fixed-income process generally and is especially important in the financials sector.

How does the fund fit within asset allocation?

JK: We believe that the Fund provides a compelling risk-return opportunity when viewed against both bank equities and corporate high yield, and that investors will continue to be well-compensated for the risks involved in this relatively complex asset class. We think AT1 securities have the return-generating properties of equity over the longer term, but with a more stable return pattern. Within the financial sector, they can be a good diversifier from existing holdings in banks’ stocks and a means of de-risking equity exposure. The benefits include lower volatility (6%–8% versus 25% for AT1s and banks’ stocks respectively4), shallower drawdowns, steady cash flow and potentially higher returns. In fact, since the launch of the AT1 market, those securities have massively outperformed bank equity on a cumulative basis. From May 2014 through May 2021, AT1s returned a positive 54.6% cumulative versus bank equities’ negative –35.8%5—a startling difference (Display, below). By comparison, the equivalent total return of the global high yield index was 27.5%. Of course, recent AT1 performance has benefited from a favourable backdrop, and we are currently seeing a revival in banks’ equity prices too. While we expect European banks’ equities to continue to rise in the near term as dividends/share buybacks are switched back on, and as analysts upgrade earnings estimates to reflect rising inflation/rates, we believe that banks’ profitability will remain at or below their cost of equity given longer-term structural impediments within the sector. This relatively low profitability (dividend production) has driven the underperformance of banks’ equity over the last few years. On the other hand, bank bonds, including AT1s, have performed well due to banks’ stronger and more liquid balance sheets with higher capital and better asset quality. So long as these improvements are maintained, the risks for AT1 investors of reductions in coupons or loss of capital are greatly reduced. AT1s also represent an alternative to high-yield corporates, without sacrificing yields. In fact, our portfolio is mainly split between BBB investment grade and BB high-yield issues, but with yields that are more akin to lower-quality B- and CCC-type high-yield corporate issuers.

¹AT1 securities are designed to provide an additional capital buffer to improve banks’ solvency. These bonds are a category of Contingent Convertibles (CoCos)—a more complex type of bond which converts to equity or is written down should a pre-specified trigger event occur. The risk of investing in these types of instruments is that the holders of CoCos will suffer losses ahead of other equity investors and may not receive the return of their investment. The generic term “AT1s” is generally used to refer to CoCos that are classified as Additional Tier 1 capital under the Basel III rules. “Legacy Tier 1” was the forerunner of the current AT1/CoCos, generally issued between the late-1990s and 2013, and predated the implementation of the Basel III rules. “Tier 2” capital is designated as the second or supplementary layer of a bank’s capital and consists of subordinated term debt and certain reserves.
²Returns quoted are for the S1 share class LU1808993833 for the period 14 May 2018 through 17 May 2021. Source for Fund and benchmark returns: Bloomberg
³Funds quoted are the PIMCO Capital Securities Fund, Algebris Financial Credit Fund and BlueBay Financial Capital Bond Fund. For full details of the complete peer group performance, please see performance table on page 5 of this document Source: Bloomberg
⁴Volatility since the launch of Bloomberg Barclays European Banks AT1 Index through 31 April 2021.
⁵Cumulative returns since the launch of Bloomberg Barclays European Banks AT1 Index through 31 April 2021. AT1s represented by Bloomberg Barclays European Banks CoCo Tier 1 Total Return Index Hedged EUR; bank equity represented by the Euro STOXX Banks Price EUR. High yield represented by Bloomberg Barclays Global High Yield Total Return Index (hedged in EUR). All data for the period from 30 May 2014 – 31 April 2021.

Portfolio characteristics are subject to change. We do not show the entirety of the Fund’s investment guidelines. Internal investment guidelines are not shown in the prospectus and are therefore subject to change without notification. As of 30 May 2021. Source: AB

Fund Performance versus Benchmark and Peers with Equivalent Mandates Focused on Subordinated Financials

(Cumulative Three-Year and Calendar Periods)

Source: Bloomberg. As at 17 May 2021.

Fund Performance v Benchmark

Complete 12 month returns %

Past performance does not guarantee future results.
Performance data is shown for the stated share class. The Fund uses the Benchmark shown for comparison purposes only. The Fund is actively managed and the Investment Manager is not constrained by its Benchmark when implementing the Fund’s investment strategy.
Performance data is provided in the share class currency and includes the change in net asset value and the reinvestment of any distributions paid on the Fund shares for the period shown. Performance data are net of management fees, but do not reflect sales charges or the effect of taxes. Returns for other share classes will vary due to different charges and expenses. Inception date: AB Financial Credit Portfolio –14 May 2018.
Source: Bloomberg and AB. As at 31 May 2021.