Commentary: Beware the triumvirate of risks

Coming into this year we firmly believed high-quality fixed income offered attractive relative and absolute value. We also expected the economic cycle to turn in favour of bonds, albeit since late last year most data was indicating resilience in economic activity and persistence in core inflation. The banking stresses that emerged in March provided the first clear evidence that rate hikes are biting, and that the cycle is turning.

Markets are digesting one of the most rapid tightenings in monetary policy ever seen, at individual country levels and collectively across countries. Although monetary policy typically works with long and variable lags, the effect of policy tightening is beginning to show, in particular via stress within the financial system itself. It’s been a very volatile quarter, but the key moves have been:

• A flight to quality, with government bonds outperforming other assets. Short-dated bond yields have plunged, driving strong returns from high-quality fixed income portfolios. In part this has been an unwind of short positioning in interest rate derivatives, but it also reflects a significant repricing of the expected path of rate hikes.
• A widening of credit spreads, but particularly in bank spreads and especially in subordinated bank issues, given the concern over the Credit Suisse AT1 bonds being written down to zero.
• Dislocated funding markets, in a scramble for liquidity. US banks usage of the central bank liquidity facilities has surged. Interestingly, however, the US dollar has traded sideways, as US rate expectations have repriced lower.

Three risks dominate markets: 1) banking system stability given the nervousness of depositors and counterparties, in spite of the swift Fed and Swiss regulator actions to stem the US regional and Credit Suisse situations, 2) the probability of a material contraction of credit availability to businesses, 3) inflation stickiness which potentially puts policymakers in a corner.

• The US bank failures and Credit Suisse takeover in March are significant developments that suggest the financial system is being extremely stressed by the rapid rise in rates. It is hard to ignore these as isolated or idiosyncratic situations.
• So far, the market is considering these risks to be relatively containable, but nervousness is clearly gathering momentum and banks survive on sentiment and depositor confidence. We expect to continue to see a flight to quality and higher-rated banks will gain additional market share as a result of these developments.
• Our view is that central banks cannot raise interest rates at the recent speed and magnitude without some level of creative destruction.
• The market dislocation may be contained by swift central bank and regulator responses, however we expect the resulting restriction of credit to the economy will accelerate the anticipated slowdown in growth.
• Central banks are likely to be more cautious in tightening further from here. This may involve both a slower pace and lower peak cash rate.
• Rate cuts (at this stage) are unlikely to be delivered in 2023, as the fight against inflation remains the priority. However, all else being equal, the emergence of banking system stress and the likely credit tightening for the real economy are likely to help central banks in their fights against inflation.
• Together this leaves risky assets vulnerable while high-quality bonds look increasingly appealing. We do, however, expect volatility to remain high and expect to see sharp moves in both directions.

• To date, these events have largely been confined to the banking sector. Corporates, especially those with large fixed asset bases, will soon be feeling the impact of higher interest rates through negative mark to market adjustments and what is highly likely to be a period of credit rationing by the banks and debt capital markets. More generally, corporate models that were viable in periods of ultra-low rates and abundant capital will be stressed.

Positioning

• Our portfolios have held moderate long duration positions and are positioned for yield curves to steepen, which have benefited performance. We are waiting for opportunities to further increase duration, particularly in US Treasuries. Treasuries are particularly appealing because of the high rate structure in the US and their high quality.
• Our credit allocations have been concentrated in high-quality Australian investment grade issuers, with small allocations to Australian mortgages, and Australian higher yielding credit. We are running net short positions in both US high-yield and US investment grade sectors. Although we are likely to see some further widening of credit spreads as the cycle enters the downturn stage, investment grade spreads are already pricing a recession and therefore offer good medium-term value. However high-yield spreads appear vulnerable to a material repricing as downgrades/defaults pick up.
• Within our Australian credit allocations we have been rotating issuers to improve overall credit quality; buying banks from an underweight position, and de-risking by reducing lower rated credit issuers. We are confident that Australian banks are well positioned, with simpler business models and high liquidity and high capital levels.

High-quality fixed income offers attractive income levels and improved diversification benefits as the cycle turns. We are positioned constructively in interest rate duration and high quality corporate debt, and expect to become even more constructively positioned through the year.

Learn more about the Schroder Fixed Income Fund.