Fixed income: Bond managers tread with caution

The bank crisis – triggered by untameable interest rates – has brought fresh challenges in the fixed income universe. Piyasi Mitra explores friendly and not-so-friendly investment options.

The Silicon Valley Bank (SVB) collapse has put fixed income investors in a fix. Soaring interest rates are allegedly the villain behind the collapse, as the bank struggled with losses on bonds issued when rates were lower. About two months later, the ramifications have not been as severe as the finance fraternity might have expected, but challenges persist in the bond’verse.

Banks – in particular the likes of SVB – have seen uninsured deposit growth over the past few years. As a US-based asset manager (speaking anonymously) points out, SVB had assets it needed to invest by putting deposited money to work while retaining the net interest margin. “The low coupon securities they bought included treasuries, especially agency mortgage-backed securities (MBS) displaying negative convexities when interest rates rise. This occurs when the bond’s duration increases in tandem with yield increase and is bad for prices on securities.”

The SVB debacle exposed players who failed to ace the risk management game by hedging out that negative convexity with interest rates, says the asset manager.

Good bonds, bad bonds

Following the fiasco, many investors are shunning not just high-yield bonds but also investment grade (IG) bonds, he notes. “Spreads on investment grade bonds are shooting up. For instance, US corporate market IG bond spreads have recently widened significantly from 120 to 180 basis points.”

Investors are not keen to put money to work under such uncertainty threatening the banking sector, anticipating a ripple effect in many areas of the economy. “They need more clarity on the kind of security central banks will provide, and even regional banks need reassurance to put new money to work. Marginal selling is pushing spreads wider because nobody is willing to step in and buy on the other side,” he says.

“Outside of the banking sector, rating agencies will have to stay on top of earnings to observe how tighter monetary conditions and a weaker economy are going to impact the industrial sectors.”

He also envisages that with an improved risk scenario, buyers might come in to take advantage of pushing spreads tighter. On the flip side, uncertainty might push investors to the sidelines, and spreads would continue to widen. “Optimism prevails, but the tail risk of timely support not arriving is so significant that investors expect better compensation,” he says, admitting it would be overambitious to expect a return to the January bond rally.

After the banking debacle, the focus of central banks has shifted to “growth fears”, the asset manager adds. “How central banks will strike a balance between fighting inflation and restoring a stable financial climate will be key.”

Amid investor fears of contagion throughout the financial sector, the EU’s economy commissioner claimed that the collapse of SVB in the US did not pose a serious threat to Europe. The Bank of England, too, has switched on its ‘heightened alert’ mode for further banking turmoil, and in Europe, UBS bought Credit Suisse to avoid further disruption.

Rating realms

This might be a good time to reassess the role of credit ratings in the fixed income space. Banks should largely be able to cope with ‘unrealised losses’ on bonds and the collapse of SVB, stated S&P Global Ratings. “At this stage, we view the risks from unrealised losses as manageable,” the rating agency said in March.

S&P Global Ratings had rated SVB as ‘investment grade’ until its collapse. The ratings firm lowered its issuer credit rating on SVB to ‘D’ from ‘BBB’ and pointed out that a risk-adjusted capital inclusive of unrealised gains and losses would become more volatile – plausibly distorting the “true picture of a bank’s capital adequacy when we do not expect the bank to realise those gains and losses”.

“While regulators and policymakers have reacted swiftly in dealing with the problem banks, the market fears that the problems run deeper. Relatively weaker institutions would continue to face market mistrust until a risk overhang clears.”

It highlighted that for some banks, the higher rates had caused a decline in the value of fair-valued financial assets they hold in their balance sheets. This stress could contribute to deterioration in a bank’s credit profile, as demonstrated in the SVB case. “We see the risk of significant unrealised losses materialising to be broadly contained for banks we rate, although we expect it to be most pronounced in banks with a more concentrated business model or funding profile. The best-protected banks will continue to avoid credit and market risk concentrations and retain solid capital and liquidity metrics,” stated S&P Global Ratings.

Credit rating agencies evaluating banks, balance sheets, assets, deposits, profitability and so on will have to make assumptions about those factors in order to be able to rerate the banking industry, suggests the asset manager. “Outside of the banking sector, rating agencies will have to stay on top of earnings to observe how tighter monetary conditions and a weaker economy are going to impact the industrial sectors,” he says.

Banks in Asia-Pacific can heave a sigh of relief for now, as S&P Global Ratings is yet to detect any meaningful contagion in the region from the turmoil of US regional banks and Credit Suisse. “Asia-Pacific banks generally have more conventional asset and deposit profiles. We, therefore, see the contagion risk as moderate, albeit worsening,” it reported. Their asset books tend to be conventional, broad-based lending across commercial and retail segments with a much lower proportion of fixed-rate assets under holding than is the norm in the US.

Risks, returns, rewards

Jayadev Mishra, co-portfolio manager of the global high-yield fund at J Safra Sarasin, a Swiss private bank, observes that while the SVB collapse reflected poorly on the bank’s internal asset-liability management and prompted questions about the regulatory framework, the critical issue is that of “market confidence and liquidity”.

The same is also evident in the Credit Suisse situation that unfolded under a different regulatory framework, he points out. “While regulators and policymakers have reacted swiftly in dealing with the problem banks, the market fears that the problems run deeper. Relatively weaker institutions would continue to face market mistrust until a risk overhang clears.”

Conventional investors having the mandate to take duration and interest rate risks will face elevated and volatile interest rates, cautions Mishra. “For example, pension funds looking for long-term yields of approximately 4% could have switched to high-quality, long-duration bonds locking in such returns in the recent past. They need not take the risks they took previously to get to that return.”

Consequently, the demand for alternatives and equities from pension funds may reduce, causing a shift in asset allocation, says Mishra.

Additionally, real estate investments that thrived on lower-cost borrowing to develop portfolios currently seem to be realising subpar yields, to say the least. Such assets would need to realign over the medium term in terms of valuation.

“Parts of mortgage debts that were sold to investors over the past year through MBS or similar structures would lead to markdowns, thus eroding significant investor wealth as such securities price in the higher yield environment,” adds Mishra, emphasising that high yield markets will need to re-evaluate the business case for incrementally borrowing money against the return prospects of those investments.

“We particularly like US duration since the end of the current hiking cycle seems more foreseeable and potentially closer.”

Overall, as he sees it, debt as a financial discipline tool will come to the fore, and investors using cheap borrowing as a business model will perish or evolve. An increase in yields adds both risk and opportunities for investors in fixed income, he notes.

Elevated volatility tends to hurt high yield in the near term, Mishra adds. The recent spike in volatility, for example, led to more than a 100bps widening in high yield spreads from the lows at the beginning of March. While Mishra estimates more widening under economic deterioration, the current spread levels (at the time of writing) more than compensate for expected defaults over the next 12 months, making the asset class strategically more interesting. “From a bottom-up perspective, we believe the current uncertainty and elevated spread levels are a hurdle for issuers needing to raise capital through bond issues. However, those not in dire need should wait for better conditions. As such, we prefer issuers with sound liquidity not needing access to capital markets in the near term.”

Active management in a careful selection of the right bonds can help investors navigate through volatile phases, he says. “Combining traditional credit analysis with a sustainability overlay can provide defensive exposure to a market now offering much more attractive longer-term yields.”

The trend appears to be “overly bearish” for certain good-quality issuers in the broader financial sector, offering some bargains for fixed income managers to pick up. However, a key challenge is an efficient execution amid reduced market liquidity, Mishra explains, advising investors to factor in the probability of completing a deal in addition to its “attractiveness”.

He adds: “With structurally shrinking risk appetite of flow trading desks, this has become the new normal for high yield managers. Sourcing the bonds you want at a decent price is critical.”

High yield horizon

The Federal Reserve’s goal remains to bridge the gap between the number of jobs available and the number of people searching for a job. However, considering recent Fed rate hikes to try to achieve this, Abdelak Adjriou, co-manager of the FP Carmignac Unconstrained Global Bond fund, expects the credit and real estate sectors, in particular, to continue to show some signs of weakness.

Capital costs have spiked, putting at risk refinancing for smaller or weaker companies, points out Adjriou, who also expects some emerging markets, with higher current account deficits and important refinancing in US dollars, to face some headwinds. The question is: how far can central banks go before causing a housing/real estate and banking sector breakdown?

“We expect the Fed will continue to aim for wages and employment stabilisation, considering that their cues of a ‘slowing in inflation’ have been removed from the central bank’s statement. This could push the Fed to increase key rates once again and retain them for a few months later, indicating a potential stabilisation of the terminal rate,” adds Adjriou.

A recession could bring more volatility to credit markets and spread products, particularly the high-yield sector – at least on the short-term horizon, he says. “Although the current HY levels are interesting for longer time-horizon investments, we remain cautious on this space in the short term, waiting for the recession to be more clearly priced in.”

Duration and ‘yield curve’ strategies should do well amid an approaching recession. “We particularly like US duration since the end of the current hiking cycle seems more foreseeable and potentially closer,” says Adjriou. He prefers rate strategies in local currency within the emerging markets space, specifically in those countries where “real rates are very high”, for example, in Latin America.

His firm has implemented protection in the “credit sector and spread products” space, he adds, while waiting for the recession that is clearly priced in by the market. “We also continue to manage currencies actively as they have proven beneficial both in 2022 and 2023 year to date.”

© 2023 funds europe

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