Fixed income perspectives: Pardon the interruption

Fed tightening plans have been upended by bank scares. The sudden failures of several US regional banks, followed by the collapse and subsequent sale of Credit Suisse, forced a timeout on the market’s obsession with inflation and interest rates. We believe recent developments do not appear systemic in nature, but are rather the result of mitigating circumstances at the specific institutions. However, the Fed, seeking to avoid further “accidents” tied to higher rates, hiked by just 25 basis points. Overall, we believe bank balance sheets are healthy, and the lack of fundamental consumer and corporate imbalances should limit the severity of any sort of economic downturn that may materialize.

The long game still needs to play out. We believe the quick actions by regulators have largely addressed concerns of systemic risk in the banking system. However, a higher cost of capital for banks will flow through to higher borrowing costs for both companies and consumers, driving our view of a potentially longer (but still shallow) recession. Further Fed rate hikes may be unnecessary given that the challenges to the banking system should be disinflationary. The focus now shifts to when the Fed might start to shift policy towards lower rates. For that to happen, we believe labor markets and economic growth would need to weaken substantially — and that isn’t happening yet. Employment data remains vibrant (despite an uptick in the unemployment rate) and the economy has remained remarkably resilient, supported by a strong consumer.

Good news may come with bad news. Over the past several weeks interest rates have plunged, with the 2-year Treasury yield at one point more than 1% lower than it was earlier this month, and with the 10-year Treasury dropping from above 4% to near 3.5% over the same period (Exhibit 1). While credit conditions are likely to be tighter going forward, lower Treasury rates will help offset some of this tightening.

Following the failure of Silicon Valley Bank, bond and credit markets have remained orderly. Though spreads have widened across the board, most if not all markets are functioning well, albeit on less volume. Volatility is elevated but not to the level of panic. The biggest damage to spreads has been in the financial sector, the brunt being borne by niche regional banks. Money center bank bond spreads have widened only slightly, and the largest banks have recently been gaining market share.

For long-term investors able to ride out near-term volatility, we believe these conditions signal a potentially appealing entry point into credit markets. Tactical opportunities may be taken without overstretching a portfolio’s risk profile or sacrificing trading liquidity. We’re drawn to investment grade corporates and high yield (ex-CCCs) to capitalize on the market re-pricing from the SVB disruption, as well as strategies to capitalize on elevated interest rate volatility. To paraphrase an old proverb, with crisis comes opportunity, and we’re seeing plenty of opportunities as we speak.

Investment grade: Spreads have widened following bank failures, but we don’t see the risk of contagion to the corporate sector as being very high.

High yield: Liquidity and trading volume have diminished, but there is no sense of panic in the high yield sector.

Senior loans: Despite the recent banking news, senior loan markets have been open for business, and spreads are at attractive levels.

Securitized credit: Though spreads have risen, we see no evidence of forced selling, and markets are functioning normally.

Agency RMBS: We expect agency performance to be primarily impacted by swings in rate volatility as investors assess prospective Fed policy and economic surprises.

Emerging markets: Absolute yield levels remain attractive compared to historical norms, though the prospect of a global recession will keep spreads elevated.

Global rates and currencies

• Following the defaults of Silicon Valley and Signature banks, markets are forecasting a lower “terminal” fed funds rate of about 5% rather than the 5.75% level of earlier this month. We agree with the market’s assessment.
• The Fed had signaled that a 0.50% hike could have been on the way in March, but concerns about the financial system eliminated that possibility.
• Global inflation and economic activity among developed countries have been higher than expected, prompting major central banks to remain hawkish. Only Japan’s BoJ has remained committed to an ultra-low rate policy.
• Talk of a European recession has cooled along with warm weather and relief in energy prices. China’s economy has shown surprising strength following the end of severe Covid measures.

Investment grade (IG) corporates

• IG spreads have widened following the sudden stress to the financial system, but markets remain orderly and calm.
• Much of the spread weakness has been concentrated in the financial sector, with money center banks widening by 10-15 bp, regional banks by about 50 bp, and third-tier regionals by about 100 bp.
• IG spreads had risen in February as interest rates increased and markets discounted a generally higher rate environment.
• New issue supply was record-breaking in February at $152 billion (despite a short month), well above the $95 billion 4-year average.
• New issue long-dated supply was impressive, suggesting corporate treasurers have been expecting rates to remain elevated for some time.
• Unlike in other sectors, IG ratings trends have remained positive, with corporations well-positioned to ride out economic slowdowns.

High yield (HY) corporates

• The failure of Silicon Valley and Signature banks has led to diminishing liquidity and reduced trading, but there is no sense of panic.
• HY bond prices moderated slightly in February following a very strong January, though the riskier names remained well-bid going into March.
• With financial stress now reflected in spreads, we think current prices remain attractive relative to fundamentals, and we remain moderately positive over the short term.
• As we’ve expressed in the past, over the longer term the main driver of the sector will be the strength of the recession, should a slowdown materialize. The market is pricing in a slowing economy, but not a severe weakening.
• We’re overweight building products and independent energy, and underweight financials and consumer cyclicals.
• HY default expectations remain low, but the trend seems to be upward.

Senior loans

• Following the news of the demise of SVB and Signature, loan markets are orderly and remain subdued.
• Fundamental conditions will likely drive the outlook for loan markets, despite some financial stress. To date the US economy has remained resilient.
• Corporate earnings have been weaker than expected, raising the prospect of downgrades and defaults.
• Downgrade themes include earnings, margin pressure, elevated leverage, rising borrowing costs, and exposure to weak financial institutions.
• There were two defaults in February: Avaya and Yak Mat. The 12-month trailing default rate rose to 1.01%, historically still low but rising quickly.
• In line with our cautious outlook, we’re overweight defensive sectors such as utilities, packaging, restaurants, and gaming and leisure.

Securitized credit

• Securitized spreads have widened following the collapse of Silicon Valley and Signature banks, though to a moderate extent, with CLOs and CRTs exhibiting the highest beta.
• Credit conditions have weakened, but there has been no evidence of forced selling. We’re paying close attention to trading patterns and remain vigilant.
• We’ve updated our outlook on CLOs to positive over the short run. Longer term, our main concern is the potential for fundamental economic weakness.
• We continue to be positive on RMBS, given the fundamental strength of the housing market.
• Within CMBS, the market has continued to struggle to find sponsorship for risk tied to maturing loans broadly, and especially risk tied to office properties.
• We remain positive on consumer ABS as new issue supply is modest, and most consumers remain financially healthy.

Agency RMBS

• We expect agency performance to be primarily impacted by swings in rate volatility as investors digest/predict/react to the Fed's rate path and economic surprises.
• Supply for this year is expected to be close to the $550 billion in issuance during 2022.
• The Fed portfolio of agency RMBS is set to continue in run-off mode, while bank demand remains erratic. International demand remains inconsistent.
• Despite lower rates, prepayment risk remains subdued for most of the MBS market.

Emerging market (EM) debt

• A rise in US rates during the month of February led to weakness in EM bonds.
• After a particularly large issuance of $69 billion in EM debt in January, new supply in February contracted to $24 billion. For the month, there was a total of $1 billion in net outflows for the sector.
• We remain overweight Latin America and underweight Asia ex Indonesia. In terms of credit quality, we favor higher-rated, higher-quality securities over speculative issues.
• Larger economies, particularly China and Europe, have proven stronger than expected, lending support to EM bond markets.
• Absolute yield levels remain attractive compared to historical norms, though the prospect of a global recession will keep spreads elevated.