Written by: Insight Investments
The consequences of the Federal Reserve's (Fed) rapid tightening of monetary policy started to become clear in the 1st quarter as higher rates started to expose weak spots in the financial sector. The first casualty was California-based Silicon Valley Bank (SVB), which was reported as suffering significant losses on long-dated U.S. Treasury holdings. Regulators were forced to step in to guarantee deposits, but this wasn’t sufficient to prevent Signature Bank becoming the next casualty as markets started to pick off those regional banks perceived to have vulnerabilities. With fears of a new banking crisis, negative sentiment started to ripple out from the U.S. and across to Europe, ultimately forcing a regulator-driven takeover of Swiss bank Credit Suisse by UBS.
The Federal Open Markets Committee raised rates by 25 basis points (bps) at its March meeting, following a 25bps hike in February, but noted the stresses in the banking system and the potentially tighter lending standards that would result. Markets shifted to expect a further 25bps hike in May, with that marking the terminal rate of the current cycle.
Although we’ve long highlighted that the Fed generally tightens policy until something breaks, as Alfred Hitchcock said, “there’s a distinct difference between suspense and surprise.” The abrupt change in market sentiment seen in March highlights the importance of hedging plan liabilities and locking down certainty.
We believe credit markets now offer significant opportunity
Navigating the last 15 months proved difficult for fixed income investors; yields across risk-free and credit markets forcefully shifted upward for several well-established reasons, inflicting considerable losses on bond portfolios.
However, while this period represented a significant challenge for fixed income investors, we believe the resultant normalization in yields potentially represents the best opportunity for fixed income investors to exploit in the preceding 15 years. There are now considerable opportunities to use credit to enhance income generation, and the potential to achieve long-term return objectives via income alone.
Investment grade credit: We believe the recent collapse of two regional banks in the U.S. and the troubles at Credit Suisse are more of a result of idiosyncratic issues rather than necessarily being the start of a broader systemic financial crisis and policymakers have moved quickly to restore confidence. A key question remains as to how much these issues will lead to tighter financial conditions and what impact that will have upon economic growth. We believe the widening in spreads following this mini crisis presents an attractive opportunity to add some risk in investment grade credit. Although central banks face a tricky balancing act, headline inflation appears to have peaked globally; supply chain bottlenecks have largely dissipated, and commodity prices have softened. This should give central banks greater flexibility as inflation returns towards target, and economic activity appears to be weathering the storm, at least for now. The income provided by investment grade credit is sufficient to provide attractive returns and help to mitigate any potential increase in government bond yields. There is also the potential for spreads to rally later in the year if confidence grows that rates have peaked, and if a recession has been avoided.
High yield credit: High yield credit remains extremely well positioned relative to previous downturns. Just 5% of European high yield issuers have debt maturities in 2023, and 80% of the U.S. high yield issuers have no material maturities until 2025. We expect default rates to gradually trend upward to around 3% in 2023. We expect a strong positive return over the year given current market conditions. Although positive on the market as a whole, we remain conscious that the economic environment is likely to be slower than for some years. This leaves us tactically positive and seeking value in selective names and sectors that we believe have positive long-term fundamentals.
Structured credit: Although labor markets remain tight, some signs of stress are starting to emerge in the subprime borrower segment where elevated food and gas prices are increasing pressure on higher risk borrowers. Subprime issuers are now starting to reach the limits of how much of their increased funding costs they are able to pass on to consumers, and loan demand is already limited given the increase in rates. This demonstrates the importance of our bias to issues with seniority in the capital structure, robust transaction structures that divert cashflow in the event of underperformance, and strong underwriting and servicing policies, all of which should act to insulate investors in even a severe economic downturn. We believe that demand for issues at the top end of capital structures is likely to remain robust as investors increasingly value the protection they provide. Issuer selection remains of utmost importance, especially when taking exposure to higher risk issues.
Municipal bonds: With growth slowing, the credit environment for municipal issuers is likely to be more challenged in 2023, as tax revenues are dampened. However, the widening in credit spreads in 2022 already reflects this outlook to a degree. We see the vast majority of municipal issuers as well positioned to manage near-term fiscal stress due to overall balance sheet strength that has been built up from a combination of better-than-expected tax collections and federal aid distributed in recent years. Furthermore, many municipal issuers provide essential services and either retain independent rate setting authority or unlimited taxing power to increase revenues as needed. The municipal bond yield curve slope remains inverted under 10 years, which limits incremental yield pickup by maturity extension for short-to-intermediate portfolios, solidifying our rationale for positioning to keep these portfolio durations below or near benchmark levels at least in the near term. In this environment we believe a barbell strategy with overweight positioning of short-dated bonds (for liquidity and reinvestment opportunities) along with an allocation to longer maturities should improve performance potential.
Key Market Risks
Further dislocations in the financial system as a result of Fed policy
As it attempts to bring inflation back under control the Fed has aggressively tightened policy, increasing the pace of its interest rate hikes and reducing its balance sheet. With policy being tightened at a pace unseen for decades, the financial system is under increasing pressure. The U.S. dollar has climbed to levels which are problematic for other central banks and regulators have had to step into a number of regional banks who appear to have been overly exposed to the rising rate environment.
Events in Europe spiral, causing market dislocations around the world
Tensions between Russia and the West have reached levels not seen since the Cold War, and the risk of an extreme event is growing. This could take the form of a chemical or nuclear attack on Ukraine, a coup in Russia or a direct conflict between Russian and NATO forces. There is also a risk that other countries such as China or India get drawn into the conflict and/or Western sanctions.
Tensions between China and the US spill over into conflict
The Biden administration has explicitly extended the American defense shield over Taiwan and repeatedly stated that American troops in the region would regard an invasion of Taiwan as a basis to engage. This would have monumental implications.