Idea of the Week: Investment grade and >4% yields? It’s right here

• Commerzbank continues to see good momentum in its performance with net interest income staying relatively resilient.
  
  
• We also see improvement in mBank along the way, which now providing strong, positive earnings to the Group.
  
  
• Commerzbank’s profitability will likely be sustainable, albeit we do not see exceptional growth drivers for now.
  
  
• Commerzbank holds a robust capital position with a substantial buffer, and its liquidity position still extremely decent. 
  
  

Since our previous update for Commerzbank Aktiengesellschaft (“Commerzbank”), the strong performance of the German bank has garnered another credit rating upgrade by S&P Global Ratings. While credit spreads tightened as the upgrade pushed Commerzbank’s Tier 2 notes into full investment grade, we continue to find the Tier 2 notes relatively attractive to those of other major banks. 

For the nine months ended 30 September 2024 (“9M24”), Commerzbank still sees a good momentum in its results, with revenue increasing by +1% year-on-year (“YoY”) from EUR 8,052m (9M23) to EUR 8,150m (9M24). While growth in net interest income (“NII”) has somewhat stalled (+0.1% YoY), momentum was predominantly driven by continued growth in net commission income (“NCI”) – up +4.1% YoY from EUR 2,587m in 9M23 to EUR 2,693m in 9M24.

Commerzbank’s NII declined marginally across the quarters in 2024, largely within expectations given the European Central Bank’s rate cuts since May. That said, the bank’s NII stood relatively resilient in the face of the downward pressure on interest margins – with 9M24 NII higher than that of the previous year. We expect the downward pressure on interest rates to continue, similar to the management’s own expectation. The management projects 4Q24 NII to decline further to approximately EUR 1.9b (as compared to 3Q24’s EUR 2.0b), although overall NII for FY24 will likely be roughly similar to FY23.

Meanwhile, the driver for Commerzbank – the growth in NCI contributed greatly to the bank’s continued strong showing in 2024 thus far. The higher NCI was primarily due to positive trends in the stock markets, alongside improved loan syndication and bond issuance business. Additionally, Commerzbank noted that the consolidation of Aquila Capital Investmentgesellschaft mbH (“Aquila Capital”) – an investment management company acquired in 2Q24 for EUR 200m – also has a positive impact on NCI.

 

Stability in performance

However, Commerzbank’s operating result fell -1.0% YoY from EUR 2,865m (9M23) to EUR 2,837 (9M24), albeit the net result increased by +10.1% owing to lower taxes (by EUR 215m) against the prior period. Focusing on the operating result, the drop was mainly due to increased provisions for risk results, offset by a marginal decline in overall costs. 

Risk results (i.e. expected credit losses) rose to EUR 529m in 9M24, a considerable jump from the previous period’s EUR 367m. Commerzbank’s management attributed the increment to defaults by individual counterparties and additional provisions required for the Corporate Clients segment. Nonetheless, the overall non-performing exposure ratio remains low at 0.9% of the total loan portfolio as of 3Q24, relative to 1.0% as of 3Q23.

Overall Group costs fell from EUR 4,806m (9M24) to EUR 4,780m (9M23), primarily due to lower compulsory contributions for the European bank levies to the Single Resolution Fund. Underlying operating expenses increased at a well-controlled pace of +2.2% YoY, as most of the inflationary pressure have been partially offset by active cost management. Cost-income ratio (“CIR”) stood at 58.7% for 9M24, slightly below the 59.7% observed for the prior period. The management expects the CIR to average around 60% for FY24.

Chart 2: Commerzbank’s Operating and Net Results, as well as the risk result

mBank’s woes were reduced considerably

The improvement in mBank’s performance has been significant, with excess earnings available for the Group after negating the impact of the Swiss Franc loans litigation. mBank reported an operating result of EUR 432m across 9M24, more than double of EUR 175m across 9M23. Robust earnings were supported by a substantial growth in revenue (+33% YoY), driven by an increase in net interest income for mBank.

We are mostly optimistic about the development of the Swiss Francs loan litigation given the ongoing settlements and reduction in outstanding cases. The management noted that new court cases fell more than 50% in 3Q24 against 1Q24, whereas the total pending lawsuits have greatly declined due to successful settlements with customers. For reference, current legal provisions created for the litigation now cover 140% of the outstanding Swiss Franc loans portfolio, and the proportion of outstanding Swiss Franc loans portfolio to total loans has fallen from 23.6% as of FY15 (start of the Swiss Franc loan issues) to 0.7% as of 3Q24.

We expect the impact of this litigation to gradually reduce further given the positive developments, while at the same time, any additional provisions are likely to be offset by mBank’s substantial earnings.

Commerzbank’s Outlook

Strong profitability sees great likelihood to stabilise from here

Commerzbank might no longer see exceptional drivers of growth, but sustaining the profitability is extremely feasible. This aspect is likely to be similar to other major banks, particularly considering that NII remains a substantial contributor to Commerzbank’s income.

Despite potential headwinds from further rate cuts, we anticipate a reduced impact on Commerzbank’s NII as the bank hedges its position. While the projected NII is to fall from EUR 8.2b for FY24, to a range of EUR 7.6b to 7.9b for FY25, NII is projected to instead rise to EUR 8.4b by FY27 given the hedging position and continued growth in loan volumes. In addition to this, mBank still sees potential for further earnings growth, offsetting the slight decline in NII across the broader bank if it happens.

The better-than-expected results motivated the management to project higher targets for its latest Strategy 2027 plan. By FY27, Commerzbank seeks to attain EUR 13.3b revenue (up from the previous projection of EUR 12.5b), net return on tangible equity of 12.3% (up from 11.5%) and CIR of 54% (down from 55%). While we have some reservations about Commerzbank’s ambitious targets, we still expect the profitability of the bank to be sustainable at current levels.   

Defending against a potential UniCredit takeover

Earlier in September 2024, UniCredit acquired a 9% equity stake in Commerzbank in a surprise move, with 4.49% from the German government and the remainder from market activity. The German government still holds a 12% stake in Commerzbank and reflected that it would not sell further stakes to UniCredit for the time being. Subsequently, UniCredit indicated that it has further increased its stake to 21% through the use of derivatives.

The acquisition opened up the possibility of a takeover of Commerzbank by UniCredit, a move criticised by both the Commerzbank’s CEO and the German government. There have been several concerns arising over the potential merger, albeit a rise in Commerzbank’s share price was observed following UniCredit’s acquisition of stakes. Most importantly, a merger between the two banks might see a potential downgrade in credit rating as UniCredit is rated BBB/Baa1/BBB+ by S&P/Moody’s/Fitch respectively, versus Commerzbank’s A+/A1 by S&P/Moody’s respectively.

At the moment, we believe the likelihood of a takeover is extremely unlikely – given the responses by Commerzbank’s CEO and the German government, on top of minimal benefits for Commerzbank under a potential merger. This likelihood appeared to have further diminished, with UniCredit’s recent move to acquire its domestic rival Banco BPM SpA through a EUR 10b bid via an all-shares offer. As such, we feel that bondholders need not be concerned given the overall low probability, but we continue to take note of any potential developments on this merger.

Solvency & Credit Profile

Capital remains in a strong position

Commerzbank’s capital continues to stand relatively robust, with the Common Equity Tier 1 (“CET1”) ratio at 14.8% as of 3Q24. The figure was largely flat from the previous quarter, owing to a reduction in risk-weighted assets offset by a negative foreign exchange impact on its capital reserves. The CET1 ratio still holds a significant buffer over the regulatory requirements at 451 basis points to the maximum distributable amount level. Additionally, given Commerzbank’s strong performance throughout 2024, the management revised the projection for the CET1 ratio to ~15% for the entirety of FY24. 

On the other hand, liquidity also remains decent for Commerzbank. As of 3Q24, the liquidity coverage ratio and net stable fund ratio are at 140.3% and 128.8% respectively, both of which are above the 100% regulatory requirement levels. Commerzbank reflected highly liquid assets of EUR 137.9b, which covers about 35% of total deposits held by Commerzbank as of 30 September 2024.

Table 1: Commerzbank’s capital and solvency metrics

Commerzbank upgraded

Owing to the good results, S&P Global Ratings upgraded Commerzbank’s long-term issuer credit rating from ‘A-’ to ‘A’ in August 2024, allowing credit ratings on its senior, Tier 2 and Additional Tier 1 debt to be raised by one notch. Moody’s affirmed Commerzbank issuer rating at A2, but recently revised the bank’s outlook from “Stable” to “Positive” in October. The past rate hikes came in at an opportune time for Commerzbank as it previously sought to restructure and we see the positive results translating into credit rating upgrades.

S&P expects the improved risk-adjusted profitability by Commerzbank to persist, especially on the backdrop of enhanced domestic market position and diversification. Moody’s commented that an upgrade on its rating would be possible if it shows continued progress in its strategic plan alongside a sustainably improved financial profile. 

Issues	Ask Price	Yield to Call/ Maturity	Years to Call/ Maturity	Bond Credit Rating (S&P/Fitch)
CMZB 6.500% 24Apr2034 Corp (SGD)	108.70	4.19%/ 4.97%	4.16/ 9.41	BBB- (S&P)/ Baa3 (Moody’s)
CMZB 5.700% 03May2033 Corp (SGD)	104.90	4.04%/ 4.86%	3.19/ 8.44
BNP 4.750% 15Feb2034 Corp (SGD)	103.15	3.93%/ 4.61%	4.22/ 9.23	BBB+/ A-
LLOYDS 5.250% 22August2033 Corp (SGD)	104.62	3.91%/ 4.27%	3.74/ 8.74	N.R/ BBB+
HSBC 5.300% 14Mar2033 Corp (SGD)	104.30	3.90%/ 4.23%	3.30/ 8.30	BBB/ A-
Sources: Bondsupermart, iFAST Compilations. Data as of 26 November 2024.

With the latest S&P Global Ratings upgrade on Commerzbank, the Tier 2 subordinated notes issued by Commerzbank are fully investment-grade across major rating agencies. Consequently, we have seen a great compression in the credit spreads of these papers since the upgrade, which were well within our expectations.

Despite the tighter spreads for Commerzbank now, we maintain our positive view on the Tier 2 subordinated notes. Compared to other similarly good-performing banks, both its SGD Tier 2 notes still offer more than 4% yields – a rarity that would be hard to find for investment-grade issuances in the current SGD bond space. We like both papers - CMZB 6.500% 24Apr2034 Corp (SGD) offers a higher yield in exchange for the higher ask price required, while CMZB 5.700% 03May2033 Corp (SGD) still provides a relatively attractive coupon and pricing.

We would like to remind investors that Tier 2 subordinated notes come with loss absorption features, and rank lower than senior unsecured or non-preferred notes issued by banks. This might not be suitable for all investors, particularly for risk-averse investors.

On the other hand, we expect Tier 2 subordinated notes to be redeemed on the first call date if applicable, given the incentive for issuers to refresh the capital earlier. Under the Basel III framework for Tier 2 Capital (with reference to Article 64 of the Regulation (EU) No 575/2013), Tier 2 securities that remain uncalled past the first call date will have to be amortized in the remaining five years towards maturity. We expect most banks, if not all, to refresh their Tier 2 capital earlier as a result of this regulation.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) hold a position in CMZB 6.500% 24Apr2034 Corp (SGD), CMZB 5.700% 03May2033 Corp (SGD), BNP 4.750% 15Feb2034 Corp (SGD), HSBC 5.300% 14Mar2033 Corp (SGD) and the analyst who produced this report hold a NIL position in the abovementioned securities.