Webinar Replay: Uncovering the Risks That RemainWebinarReplay:UncoveringtheRisksThatRemain

A rapid increase in interest rates created a challenging environment for regional banks. In the aftermath of Silicon Valley Bank’s collapse, turmoil in the banking sector has raised questions about the impact on lending conditions and the broader economy, as well as the possibility of new risks emerging in financial markets.

PGIM gathered a panel of experts to discuss the impact of banking stress, higher rates and economic uncertainty, exploring both the challenges and opportunities present in the real estate and fixed income markets. The panel also addressed the latest developments in Washington, from potential legislative and regulatory measures addressing fragilities in the bank sector to negotiations over raising the debt ceiling. The following is a summary of the conversation.
 

• Risks and opportunities in real estate: Lending in the real estate market showed signs of a contraction well before the recent bout of turmoil surrounding regional banks. However, banking stress, coupled with an uncertain picture of the underlying real estate market and property values, further limited credit availability. Higher rates have created a stalemate in private real estate transactions. Recent moves in the public REIT market indicate a future decline in private real estate values, and this decline could manifest itself as a slow march downward. Until there is greater certainty with respect to valuations and macro conditions, investors should look for risk premium to increase. Anticipating a higher likelihood of defaults, regional banks and insurers are engaging in proactive restructuring of their loans. There are also risks related to weaker demand for office space and its impact on regional banks, which dedicate a larger share of their portfolios to commercial real estate relative to bigger firms. Despite a murky outlook, tactical opportunities should emerge from the current environment. As lending conditions tighten and macro headwinds grow, a rise in distress sales may present investors with an opportunity to lend at a better entry point with wider spreads and higher base rates. Banks’ retreat from real estate lending also opens a door for alternate investors who can underwrite a more realistic outlook for growth, rents and inflation. Looking beyond the current cycle, non-bank lenders will have opportunities to be active in the real estate segment. Global markets face an undersupply in every form of housing, while banks are unlikely to deliver enough capital to fund opportunities. Sustainability trends will also be supportive of real estate investing because of significant financing needs.
   
• Outlook for corporate bonds: The Federal Reserve’s Corporate Bond Market Distress Index indicates that the market has held up well, despite pressure on regional banks. Regionals in the investment-grade space have about 15%-20% of their loan book on average in commercial real estate. This is one potential risk to watch, though a decline in rates triggered by bank turmoil reduced the sector’s unrealized losses. Spreads among large banks have begun to look cheaper of late. Rate volatility, which has been correlated with IG spreads, remained elevated. Debt negotiations on Capitol Hill may bring additional volatility as the X date approaches, while an anticipated conclusion to the Fed’s rate-hike campaign could bring some relief. IG names will enter a potential recession from a strong starting point. Cyclicals have fortified their balance sheets, putting them in a better position to withstand a downturn than in previous cycles. Widespread downgrades within the IG space are not likely; credit rating agencies have taken a more positive than negative posture. Corporate bond yields are down from their 2022 peaks but are still the best investors have seen since 2009, creating an attractive entry point. Investors may find opportunities in BBB companies, whose balance sheets look healthy overall. Stricter capital requirements could make regional banks within the IG market more attractive in the long run, given the potential benefits to bond holders.
   

Eyes on Washington: Thus far, there has been a lot of noise from Capitol Hill without much legislative movement. More congressional hearings related to the banking sector can be expected, but legislation that increases oversight is unlikely to pass. The Fed and FDIC have moved forward with new regulations, many of which were conceived prior to SVB’s collapse. These regulations will increase capital requirements for regional banks and make it more difficult for them to engage with certain types of businesses—rules that could present opportunities for other lenders. A Republican plan to raise the debt ceiling and reduce federal spending passed the House, presenting a blueprint for negotiations with Democrats and the White House. The House bill seemed to raise the odds of a compromise.