Credit Update: Among the various bank bonds on offer, are UBS bonds still a buy?

(Article uses data from UBS’s 2Q24 results [period ending 30 June 2024]. Dollar values are in the issuer’s reporting currency: USD.)

UBS is one of the world’s largest banks (and is Switzerland’s largest), and is classified as a global systematically important banks (G-SIB). We previously covered the Group in a few articles linked below.

We provide a credit update based on their latest 2Q24 results and explain why we remain positive on UBS and their bonds. We also detail our thoughts on recent news headlines that Swiss regulators may look to impose more stringent capital requirements on UBS.

Related article: Idea of the Week: Banking on UBS bonds to deliver yields of over 6%

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Profit highlights

(UBS reports two sets of figures: reported and underlying. Underlying figures exclude one-time effects from the CS acquisition [e.g. integration-related costs].)

UBS’s 2Q24 reported revenues came in lower (-7% QoQ) at $11.9b. This was driven by lower net interest income (NII) and other net income, but mitigated by slightly higher net fee and commission income (+1% QoQ). Among its core segments, the Personal & Corporate Banking segment saw the largest decline in revenues (-6% QoQ) as it was hurt most by weakening net interest margins (NIM), with other segments like Global Wealth Management and Asset Management delivering smaller declines (-1% QoQ) (Chart 1). We do not find this fall in revenues overly surprising considering the changing interest rates environment.

Operating expenses remained fairly stable as reported operating expenses grew by +1% QoQ while underlying operating expenses fell by -3% QoQ. The difference in reported and underlying figures can be mainly attributed to one-time integration-related expenses accounted for only in the reported figures (Chart 2).

UBS’s reported operating profit fell by -38% QoQ to $1.5b on the back of the falling revenues and stable expenses described above. Underlying operating profit also fell, though by a lesser extent (-21%) due to the exclusion of one-time integration-related expenses described above. Finally, net profits also came in at $1.1b in 2Q24, lower by -35% compared to 1Q24 (Chart 2).

To summarise, headline figures on paper indicated a broad weakening across various profitability metrics, though we think there are some normalisation effects in play this quarter (coming off highs in the previous quarter) and UBS’s core businesses remain profitable with earnings also coming in above consensus. We think UBS’s recent results continue to paint a positive picture of the issuer for now, though we will discuss more in the Outlook section below.

Chart 1: UBS Revenue Breakdown

Chart 2: UBS Costs and Profits

Outlook

We think UBS can continue its streak of profitability, though earnings growth is likely to stay within the single-digits range.

Future earnings growth will likely be driven by cost reductions and synergies. Management has disclosed they have achieved about $6.0b in cumulative cost reductions, with another $1b targeted by end-2024 (slight increase in guidance from before) or another $7b targeted by end-2026 (i.e. $13b gross). Operating expenses have also dropped a fair bit compared to recent quarters, showcasing continued progress in managing costs. We like UBS’s progress thus far in cost management, and think it remains on track to deliver further cost cuts to support profitability.

Meanwhile, we expect revenue growth to be fairly muted (likely in the single-digit percentage range), with resilience in the Wealth Management segment mitigated by lower benchmark rates.

• The Wealth Management segment is typically less rates-sensitive and has remained resilient. Net interest income (NII) saw a much smaller QoQ decline here (-2% in WM compared to -21% for UBS), while recurring net fee income continued to grow (+3%) despite an uncertain environment and net new asset inflows also remained positive.
• On the other hand, key central banks like the Fed, SNB, and ECB, have already cut rates with potentially more cuts on the horizon (priced in by markets). UBS has guided that (as of 30 June 2024) a parallel shift in yield curves by -100bps could lead to a combined decrease in annual NII of about $1.5b across the year.

Risks

As before, we think the largest risk for UBS continues to be execution risks. UBS has described itself as moving to the ‘next phase’ of integration: as it has already (recently) completed the merger of UBS and Credit Suisse in 2Q24, its next steps would be to migrate clients onto UBS platforms. As stated before, UBS’s ability to generate cost savings would heavily depend on the successful execution of this UBS-CS restructuring. While UBS has made good progress thus far, we repeat management’s phrasing that there remains ‘a lot of work ahead’.

Credit highlights

Broadly speaking, we think UBS Group remains well-capitalised for now. UBS Group reported a CET1 ratio of 14.9% (1Q24: 14.8%), accounting for its expectations for dividends and share buybacks – this increase in CET1 ratio was driven by a decrease in risk-weighted assets (RWA) by -3%. UBS’s CET1 ratio remains above the issuer’s medium-term target of 14%, as well as regulatory requirements of 10.48% (representing a buffer of +4.4%).

Other key ratios include a going-concern capital ratio (including AT1s) of 18.0%, also above the requirement of 14.8%. In addition, UBS’s total loss-absorbing capacity (TLAC) was reported at $197.7b, giving it a TLAC ratio of 38.7%, also above the regulatory requirement of 25.5%.

We note that there have been recent concerns on heightened regulatory requirements, and think there are two main impacts to consider.

The first impact relates to Basel 3.1 regulations. These requirements have not yet been finalised but should kick in on January 2025 (earlier than non-Swiss banking peers). However, management has guided for RWA to increase by 5%, representing about a $25b impact on RWA ($15b in ‘core’ RWA and $10b in ‘non-core’ RWA). As an example, keeping CET1 steady but increasing RWA by 5% would result in a still-healthy CET1 ratio of 14.2% for UBS. We expect UBS capital buffers to remain sufficient even after accounting for this 5% RWA impact.

The second impact relates to potentially higher capital requirements, as hinted by Swiss regulatory authorities in reports published in April 2024 and June 2024. News reports have indicated that UBS may have to hold $15b to $25b of additional capital (with $20b as the midpoint), but we emphasise that there remain insufficient details on the exact amount and type of additional capital UBS will have to hold (e.g. how the additional capital spread across CET1, AT1 etc.), and more details are likely to come only in 1H25.

For now, we think it is too early to speculate on the exact numerical calculations. However, broadly speaking, higher capital requirements should support the Group’s credit profile. On the other hand, it could also affect UBS’s competitiveness against its peers, though we expect regulators to keep sufficient transition time for UBS to adapt to new requirements.

Taking these together, we think that UBS continues to be an issuer with a low default probability, especially for investors who opt away from their longest-tenor bonds.

Recommendations

We compare bonds from UBS, with other bonds from peers like Barclays and Deutsche Bank. Broadly speaking, UBS will have a higher (issuer) credit rating compared to the latter two issuers.

USD bonds

Within the USD space (Table 1), UBS bonds are currently trading at fairly tight spreads (especially for shorter tenors), while investors should take note of the embedded loss-absorption clauses despite their senior status.

Of the three UBS bonds here, we think the 2028 bonds (UBS 4.253% 23Mar2028 Corp (USD)) provide an opportunity for bond investors to lock in yields for about 2+ years without undertaking excessive duration risks. We note that yields for the 2028 bonds also look fairly decent compared to the Barclays 2028 bonds (YTR of 4.2%), which is perhaps a reflection of tight spreads across many parts of the USD space. Deutsche Bank 2029 bonds also only provide a slight yield pickup, while being 1 to 2 notches lower than the UBS 2028 bonds.

GBP bonds

Within the GBP space (Table 2), UBS bonds are also trading at somewhat tight spreads, and come with similar embedded loss-absorption clauses despite their senior status.

Spreads for UBS’s GBP bonds look fairly tight, and we think investors looking for a slight yield pickup can consider BACR 8.407% 14Nov2032 Corp (GBP) instead – subordinated bonds from Barclays. These bonds offer a much higher yield of over 5.6%, likely due to their subordinated nature, though we continue to think that Barclays should be able to retain its current profitability and continues to have a low probability of default.

Related article: Credit Update: Barclays – No need to panic

Table 1: USD bonds (UBS and peers)

Table 2: GBP bonds (UBS and peers)

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

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