Credit Suisse: Five Key Takeaways
UBS saves its troubled long-time Swiss rival – what’s next?
This edition focuses on the implications from the latest developments in the global banking sector, including the acquisition of Credit Suisse by UBS.
Macro
- Our primary takeaways from UBS’ planned acquisition are mixed. From a positive perspective, the pending acquisition avoids the collapse of a systemically connected financial insitution, and the collective actions from the sovereign, regulatory entities, and central banks should support the combined entity going forward. However, the treatement of the additional tier 1 (AT1) bonds introduced a high-level of market uncertainty as it pertains to banks’ ability to refinance these instruments. Although the ECB has sought to reassure that any resolution involving Euro Area banks would see shareholders bearing losses before AT1 holders, the precedent of the treatment will surely linger. With the anticipated resolution of Credit Suisse, the focus may again turn to U.S. regional institutions.
- Although recent developments cloud the near-term outlook—not withstanding heightened geopolitical tensions and other uncertain factors (e.g., the U.S. debt ceiling)—they also improve the clarity around the limited scope for future central bank rate hikes, which we observed from the ECB last week. With the effects of tigher monetary policy hovering over the markets for more than a year, the newfound clarity points to a positive macro development over the longer run. A scenario where improved clarity restrains volatility could also indicate a supportive backdrop for credit spreads once markets move past the current crisis.
- A broad view of the potential ramifications for the U.S. economy following the events of the prior week pertain to the existence of a smaller, but longer, tail risk. The failure of SVB exposed potential fragilities within institutions with $10-$250B in assets where an average of 43% of deposits are uninsured.
- For depositors, yields on savings and deposit accounts remains well below the Fed funds target, meaning that deposits—and what is currently a low-cost of funding for the banks—may be less “sticky” and susceptible to migrating to bigger institutions. Smaller banks can use the Fed’s discount window and/or the new BTFP facility—if they possess the sufficient collateral—but at a much higher cost of about 450-475 bps.
- Given the context above, we see several key takeaways for the U.S. banking sector. When extrapolating to the concept of uncapped deposit insurance (as opposed to the current $250,000 limit), this scenario may require more loss absorption from bondholders if there will be no losses borne by depositors. However, the institutions may be treated more like public utilities going forward (a positive development for bondholders) as regulations continue to tighten (e.g., higher capital/liquidity standards, more stress tests, and more clawbacks etc.). Furthermore, amid the potential for higher funding costs, smaller banks could see greater competition from entities with relatively narrow-business models, and the broader situation could garner additional support for central bank digital currencies. Finally, the fallout could deal a blow to the net-present value of smaller banks with challenged business models.
- In terms of the economic ramifications, an ensuing credit crunch could equate to about 1 percentage point of GDP, essentially meaning no growth in 2023. However, a withdrawal of credit availability could also ease inflation pressures to the tune of at least 30-40 bps, led by domestic non-shelter services prices. That brings us to the difficult decision facing the Fed at this week’s FOMC meeting. In a more-likely-than-not scenario, we believe the Fed will proceed with a 25 bps hike accompanied by some dovish signals. The combination of recent banking developments as well as decisions from the Fed and the ECB may warrant a revision to our macro scenarios as the first quarter draws to a close.
Rates
- While liquidity in the Treasuries market is strained, the complex continues to function, particularly in comparison to past freeze-ups. For instance, the repo markets remain operational, unlike the episode in September 2019 (i.e., excess reserves appear adequate), and off-the-run issues are still trading, unlike the COVID-related freeze in March 2020.
- We’re also assessing the implications of improved clarity around monetary policy clarity for yield curves. Although a pause would lead some to anticipate a bull steepening led by a reduction in front-end yields, we’re also contemplating a scenario where a pause emerges amidst elevated inflation readings, which leads to an increase in inflation expectations due to the slower return to target inflation. This outcome could prompt a bear steepening in the yield curve led by an increase in back-end yields.
- In terms of MBS, we maintain a positive long-term view amidst the recent volatility and underperformance. Looking ahead, we continue to favor 30-year 4.5 and 5.5% issues along with specified pools and higher-coupon GNMAs in anticipation of increased demand for high-quality assets.
IG Corporates
- Looking forward to the second quarter, the landscape appears more challenging than at the start of the year: geopolitical uncertainty has increased (U.S./China and Russia/Ukraine), recession risks have risen, and Fed rate hikes have apparently raised the risk of bank failures. Corporate fundamentals are solid, but softening: earnings per share are expected to fall not 0%-5% but 5%-10% and leverage is ticking up from recent lows. In our analysis, spreads are likely to be range-bound to wider in the short term., but tighter over the longer term as the end of the Fed hiking cycle comes into sight.
- More specifically, in the portfolios we manage, we are buying bonds at wide spreads of, say, 150 bps and wider, and selling when spreads 120 bps or better. In the short term, we aim to capitalise on a resurgence of borrowing, which should come at significant concessions. Likely issuers include U.S. regional banks (who are building their capital buffers) and industrial firms (who are raising their cash holdings), which may want to make the most of lower rates and get ahead of potential disruption from debt ceiling discussions in Congress.
- In terms of individual opportunities, we view bank bonds as attractive investments at current spreads, led by money-center banks, and followed by super-regional banks and large Yankee bank issuers. BBB-rated bonds of non-financial firms don't look particularly cheap, so we may move into higher-rated bonds in this segment. As the U.S. IG yield curve has flattened, we favor short-dated bonds over longer-dated ones.
High Yield
- In the U.S., tighter lending standards have been highly correlated with default cycles. As such, we see a slightly higher probability of recession, despite the market’s less hawkish outlook for the Fed hiking cycle. Although spreads may widen when earnings outlooks fall in a recession scenario, we expect defaults to be manageable.
- With spreads in excess of 500 bps, we’re maintaining a favorable one-year outlook. While we are currently positioned defensively with a beta to the benchmark slightly below 1.0 and holding higher-than-normal cash balances, we are looking to opportunistically add higher-quality and shorter-duration risk on pullbacks from here.
- In Europe, our market beta is also less than 1 with high cash balances and credit hedging via CDX. We’re light risk in cyclicals and names with more interest-rate sensitivity. Although spreads may widen due to the increased near-term uncertainty, we’re monitoring signals to shift to a more risk-on stance.
Emerging Markets
- Although EM debt is sensitive to global growth, we don't foresee a dramatic or GFC-style sell-off in the second quarter. Instead, most of the asset class is attractively valued. Tailwinds from China, positive technical factors and high spreads/yields provide significant support.
- EM hard-currency government bond spreads widened significantly to just over 500 bps over the last few weeks. For reference, this spread was around 600 bps in July last year. Within this segment, the high-yield portion has widened most, to 923 bps, while EM IG hard-currency government bond spreads have lingered, at 164 bps as of late.
- We don't expect EM IG hard-currency government bonds to sell off. EM debt is sensitive to global growth, which is slowing down. But valuations of these bonds are attractive, economic growth in China is supportive and technicals are strong: After around $40B in outflows last year, the year-to-date has seen small inflows.
- EM HY hard-currency government bonds have already sold off significantly, so that defaults appear already priced in (many problematic sovereign credits are priced around 30%-40% of par). In addition, this category benefits from the possibility of support by multilateral organisations (IMF etc.).
- EM hard-currency corporate bond spreads have widened in the year to date, under margin pressure. But this segment is now in a solid position as well: corporate fundamentals are strong and financing needs appear limited.
- EM local-currency bonds have outperformed this year, with yields 20 bps lower than at the start of the year. Economic growth may be slowing, but many EM central banks have already reached the ends of their hiking cycles and may cut interest rates sooner rather than later. EM currencies: the U.S. dollar has weakened recently, and many EM currencies have strengthened, particularly in Asia.
- We continue to hold BBB-rated and BB-rated hard-currency government bonds and corporate bonds, we are increasing our exposure to local-currency bonds (hedged in U.S. dollars), and have reduced our exposure to EM currencies. All the while, we are maintaining room to tactically adjust the portfolios we manage as the landscape changes.
Securitized Products
- Amidst the concerns about commercial real estate, we expect growth in net operating income to slow broadly with significant dispersion across property types, and CRE valuations could be impacted by tightening lending standards from regional banks. That said, special servicers will likely modify distressed assets rather than liquidate. Near-term conduit performance is expected to fare better than single asset/single borrower assets given the former’s fixed-rate coupons and significant seasoning for most loans reaching maturity.
- In CLOs, we expect an uptick in defaults and downgrades in underlying loans, resulting in increased dispersion in CLO mezzanine performance. AAA CLOs should remain structurally protected. We believe US benchmark issuers are now ~3M SOFR+185/250/320/540/875 for AAA/AA/A/BBB/BB, respectively. We believe primary spreads will move wider in the near term as they converge towards secondary levels. In Europe, dealers continue to talk benchmark spreads in the ~3E+175 context as the manager tiering basis remains extremely compressed. However, we believe spreads will have to widen in the intermediate term to garner actionable trades.
- In ABS, we anticipate that credit quality will deteriorate for late 2021 and early 2022 vintages, and further deterioration will be tied to the inflation and recession outlook. We expect newly originated loans to outperform, and, in general, ABS structures should provide sufficient enhancement and protections with credit risk mostly concentrated at the bottom of the capital structure.
Municipal Bonds
- When looking ahead, muni fundamentals appear strong as tax collections remain elevated relative to 2019 levels, rainy-day funds hold near all-time highs, and balance sheets across sectors are padded with direct or indirect federal aid. Technicals may be challenging in the upcoming months amidst higher new issuance than expected, lower reinvestments, and stalled fund flows.
Source(s) of data (unless otherwise noted): PGIM Fixed Income as of March 2023. Chart sources are also PGIM Fixed Income
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U.S. Investment Grade Corporate Bonds: Bloomberg Barclays U.S. Corporate Bond Index: The Bloomberg Barclays U.S. Investment Grade Corporate Bond Index covers U.S.D-denominated, investment-grade, fixed-rate or step up, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements. Securities included in the index must have at least 1 year until final maturity and be rated investment-grade (Baa3/ BBB-/BBB-) or better using the middle rating of Moody’s, S&P, and Fitch.
European Investment Grade Corporate Bonds: Bloomberg Barclays European Corporate Bond Index (unhedged): The Bloomberg Barclays Euro-Aggregate: Corporates bond Index is a rules-based benchmark measuring investment grade, EUR denominated, fixed rate, and corporate only. Only bonds with a maturity of 1 year and above are eligible.
U.S. High Yield Bonds: ICE BofAML U.S. High Yield Index: The ICE BofAML U.S. High Yield Index covers US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, and at least one year remaining term to final maturity as of the rebalancing date.
European High Yield Bonds: ICE BofAML European Currency High Yield Index: This data represents the ICE BofAML Euro High Yield Index value, which tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets. Qualifying securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch). Qualifying securities must have at least one year remaining term to maturity, a fixed coupon schedule, and a minimum amount outstanding of €100 M. ICE Data Indices, LLC, used with permission. ICE DATA INDICES, LLC IS LICENSING THE ICE DATA INDICES AND RELATED DATA "AS IS," MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE DATA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THEIR USE, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND PGIM FIXED INCOME OR ANY OF ITS PRODUCTS OR SERVICES.
U.S. Senior Secured Loans: Credit Suisse Leveraged Loan Index: The Credit Suisse Leveraged Loan Index is a representative, unmanaged index of tradable, U.S. dollar denominated floating rate senior secured loans and is designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market. The Index return does not reflect the impact of principal repayments in the current month.
European Senior Secured Loans: Credit Suisse Western European Leveraged Loan Index: All Denominations EUR hedged. The Index is a representative, unmanaged index of tradable, floating rate senior secured loans designed to mirror the investable universe of the European leveraged loan market. The Index return does not reflect the impact of principal repayments in the current month.
Emerging Markets U.S.D Sovereign Debt: JP Morgan Emerging Markets Bond Index Global Diversified: The Emerging Markets Bond Index Global Diversified (EMBI Global) tracks total returns for U.S.D-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, and Eurobonds. It limits the weights of those index countries with larger debt stocks by only including specified portions of these countries’ eligible current face amounts of debt outstanding. To be deemed an emerging market by the EMBI Global Diversified Index, a country must be rated Baa1/BBB+ or below by Moody’s/S&P rating agencies. Information has been obtained from sources believed to be reliable, but J.P. Morgan does not warrant its completeness or accuracy. The Index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan's prior written approval. Copyright 2021, J.P. Morgan Chase & Co. All rights reserved.
Emerging Markets Local Debt (unhedged): JPMorgan Government Bond Index-Emerging Markets Global Diversified Index: The Government Bond Index-Emerging Markets Global Diversified Index (GBI-EM Global) tracks total returns for local currency bonds issued by emerging market governments.
Emerging Markets Corporate Bonds: JP Morgan Corporate Emerging Markets Bond Index Broad Diversified: The CEMBI tracks total returns of U.S. dollar-denominated debt instruments issued by corporate entities in Emerging Markets countries.
Emerging Markets Currencies: JP Morgan Emerging Local Markets Index Plus: The JP Morgan Emerging Local Markets Index Plus (JPM ELMI+) tracks total returns for local currency–denominated money market instruments.
Municipal Bonds: Bloomberg Barclays Municipal Bond Indices: The index covers the U.S.D-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds. The bonds must be fixed-rate or step ups, have a dated date after Dec. 13, 1990, and must be at least 1 year from their maturity date. Non-credit enhanced bonds (municipal debt without a guarantee) must be rated investment grade (Baa3/BBB-/BBB- or better) by the middle rating of Moody's, S&P, and Fitch.
U.S. Treasury Bonds: Bloomberg Barclays U.S. Treasury Bond Index: The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint but are part of a separate Short Treasury Index.
Mortgage Backed Securities: Bloomberg Barclays U.S. MBS - Agency Fixed Rate Index: The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.
Commercial Mortgage-Backed Securities: Bloomberg Barclays CMBS: ERISA Eligible Index: The index measures the performance of investment-grade commercial mortgage-backed securities, which are classes of securities that represent interests in pools of commercial mortgages. The index includes only CMBS that are Employee Retirement Income Security Act of 1974, which will deem ERISA eligible the certificates with the first priority of principal repayment, as long as certain conditions are met, including the requirement that the certificates be rated in one of the three highest rating categories by Fitch, Inc., Moody’s Investors Services or Standard & Poor’s.
Palmer Square AAA CLO DM Index represents the discount margin of CLO AAA rated tranches in the Palmer Square CLO Senior Index, which is designed to reflect the investable universe of U.S CLO senior original rated AAA and AA debt issued after Jan 1, 2011.
Global Aggregate Bond Index is a measure of global investment grade debt from twenty four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Index covers the U.S.D-denominated, investment-grade, fixed-rate or step up, taxable bond market of SEC-registered securities and includes bonds from the Treasury, Government-Related, Corporate, MBS (agency fixed-rate and hybrid ARM passthroughs), ABS, and CMBS sectors. Securities included in the index must have at least 1 year until final maturity and be rated investment-grade (Baa3/ BBB-/BBB-) or better using the middle rating of Moody’s, S&P, and Fitch.
Euro Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, euro-denominated, fixed rate bond market, including treasuries, government-related, corporate and securitized issues. Inclusion is based on currency denomination of a bond and not country of risk of the issuer.
Japanese Aggregate Bond Index The Japanese Aggregate Index contains fixed-rate investment-grade securities denominated in Japanese yen and registered as domestic bonds. The index is composed primarily of local currency sovereign debt but also includes government-related, corporate, and securitized bonds.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over U.S.D 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately U.S.D 3.4 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The DAX Index is a total return index of 30 selected German blue chip stocks traded on the Frankfurt Stock Exchange. The equities use free float shares in the index calculation. The DAX has a base value of 1,000 as of December 31, 1987. As of June 18, 1999 only XETRA equity prices are used to calculate all DAX indices.
The STOXX 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 17 countries of the European region.
The Nikkei 225 Index is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949.
Shanghai Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990.
MSCI ACWI is a free-float weighted equity index. It was developed with a base value of 100 as of December 31 1987. MXWD includes both emerging and developed world markets.
FTSE 100 is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange. The equities use an investibility weighting in the index calculation. The index was developed with a base level of 1000 as of December 30, 1983.
MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30. (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied vols with weights 0.2/0.2/0.4/0.2, respectively).
VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of the expected volatility of the S&P 500® Index, and is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes.
Bloomberg Commodity Index Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements. The index rebalances annually weighted 2/3 by trading volume and 1/3 by world production and weight-caps are applied at the commodity, sector and group level for diversification. Roll period typically occurs from 6th-10th business day based on the roll schedule.
The U.S. Dollar Index indicates the general international value of the USD. The USDX does this by averaging the exchange rates between the USD and major world currencies. The ICE US computes this by using the rates supplied by some 500 banks.
2023-2432
Fixed income instruments are subject to credit, market, and interest rate. Emerging market investments are subject to greater volatility and price declines.
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