As panic subsides following events at SVB and Credit Suisse, the Q1 2023 review from Jeff Boswell, Head of Alternative Credit, and Tim Schwarz, Portfolio Manager, finds a familiar pattern in credit markets.
The positive total returns posted by many credit markets in Q1 mask a significant amount of volatility. After a strong start, sentiment faltered as various macro data prints caused a shift in expectations towards tighter monetary policy. The collapse of Silicon Valley Bank (SVB), shortly followed by the UBS takeover of Credit Suisse – which included the Swiss regulator’s controversial decision to allow equity holders to retain some value after writing off Credit Suisse’s bank capital debt (AT1s) to zero – made for an eventful quarter.
As alarming as these events were, a familiar pattern has since emerged in credit markets. Last year, a blanket sell-off drove down dispersion across different quality segments of the credit market – leaving investment-grade (IG) valuations particularly attractive within the corporate bond market. Market dislocation seen in Q1 once again means that credit investors can capture historically attractive yields without having to compromise on quality.
Jeff Boswell, Head of Alternative Credit and Tim Schwarz, Portfolio Manager:
“The collapse of SVB closely followed by the Credit Suisse debacle brought significant contagion fears and volatility to the banking sector in Q1. Bonds sold off across the capital structure and in a correlated way for both higher quality and lower quality issuers.
“This has brought interesting opportunities, with the larger, higher-quality banks appearing the most attractively valued on risk-adjusted basis across the capital structure.”
The rapid sell-off has left bank sector credit spreads at their widest levels in 10 years relative to the overall corporate bond market. Elsewhere in the global credit universe, the market for bank capital instruments – commonly referred to as Contingent Convertibles (CoCos) – saw spreads widen substantially.
Even though a partial recovery has taken place, CoCo spreads remain close to levels seen during the COVID crisis and CoCos now trade at the largest spread pick-up vs. US high yield on record – despite CoCos carrying an average rating that is three notches higher than the US high-yield market average.
A further observation following the recent sell-off is that within the senior (investment-grade) part of the bank sector capital structure, front-dated bonds underperformed. Boswell and Schwarz continue: “This has created opportunities for investors to capture outsized yields in short-duration risk, which typically displays much lower volatility than broader credit markets through time. In addition, this differentiation in the credit spread by maturity is much less pronounced in IG bank bonds than it is in the overall IG corporate bond index. This phenomenon, commonly referred to as a flat curve, highlights the significant value to be found in front-dated bank sector bonds.”
Similarly, within the CoCos market, there is a low level of differentiation between credit spreads across the credit quality spectrum, especially compared to that seen in the corporate bond market. The upshot is that investors get only slightly less spread for taking a lot less credit risk.
Boswell and Schwarz said:
“Negative tail risks remain for both the banking sector and broader corporate universe, with a wide range of economic outcomes possible over the next year, given the challenging macro backdrop; selectivity remains key.
“The nature of the recent banking sector sell-off has allowed us to continue in our quality orientated search for yield. We continue to find most value in the larger, higher-quality national banks given their diversified funding mix, high capitalisation levels and conservative balance sheets, and believe these issuers are well placed to navigate the multitude of possible economic scenarios in the year ahead.”