Strategic Bond update: Bank woes should hasten peak in rates
Co-Heads of Global Bonds Jenna Barnard and John Pattullo provide an update on the Strategic Bond Strategy and how recent events in the banking sector add weight to their view that interest rates have peaked.
6 minute watch
- The issues in the banking sector are linked to the rapid pace of interest rate hikes as it exposes pressures in the system.
- Tighter financial conditions are likely to hasten the end of monetary policy tightening. It is not uncommon for rate hiking cycles to be short-circuited by events, as happened in the US in 1984 and 1994.
- We remain defensively positioned, principally in government bonds and investment grade corporate bonds which we believe are best positioned to benefit from declining rates. We have no holdings in AT1 bonds that have been at the centre of the fallout in the banking sector within Europe.
Co-Co bonds: Contingent Convertible bonds are bonds that, upon a predetermined ‘trigger event’ can be converted into shares of the issuer or are partly or wholly written off. In recognition of their higher risk, investors in these bonds typically receive high interest payments.
Coincident economic indicators: A data series that gives a signal of where we are in the economic cycle.
Cycle: The fluctuation of the economy between expansion (growth) and contraction (recession). It is influenced by many factors including household, government and business spending, trade, technology and central bank policy. Late cycle describes the period immediately prior to an economic downturn.
Deposit beta: Sensitivity of deposit flows.
Duration: How far a fixed income security or portfolio is sensitive to a change in interest rates, measured in terms of the weighted average of all the security/portfolio’s remaining cash flows (both coupons and principal). The larger the figure, the more sensitive it is to a movement in interest rates. ‘Going short duration’ refers to reducing the average duration of a portfolio. Alternatively, ‘going long duration’ refers to extending a portfolio’s average duration.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high-yield bonds.
Landing: No-landing is the notion that the economy can avoid an economic downturn. Soft landing describes tightening by central banks that causes only a mild economic downturn. Hard landing is where the economy suffers a recession.
Liquidity: The ease with which securities can be traded, assets can be converted to cash and money flows around the economy. Tighter liquidity refers to when conditions become harder to do the above.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money
Non-cyclical: Companies that are less sensitives to the ups and downs of the economy. This is because they operate in a sector that has steadier demand such as healthcare or food or because specific aspects of their business, such as a unique product or differentiated service mean they tend to outperform the market during an economic slowdown.
Sovereign bonds: A bond issued by the government of a country to support public spending. Quality sovereign bonds refers here to bonds issued by developed market governments with a high credit rating.
T-bills: A shortened name for Treasury bills, which are US government bonds with short maturities.
Jenna Barnard. Today is Monday 20th March. It is just a brief update from John Pattullo and myself, Jenna Barnard, on the strategic bond strategies that we run. The first thing I should say is that the events of the last week do look to have dramatically changed the investment landscape. And I’d like to thank clients for their persistence and patience with our own positioning which, over the last year, has skewed to longer-duration government bonds and away from credit and particularly esoteric asset classes like AT1, CoCo bank bonds.
We are very defensively positioned, and we were following, as you know, a cycles process that led us to think we were in a very late-cycle moment where the coincident economic indicators were beginning to turn over, and the likelihood was we were heading into recession in most major developed economies this year.
The events of the last week I think give us additional conviction in that. The idea that these banking sector problems are idiosyncratic is as farcical as the no-landing hypothesis of a month ago, and exactly the kind of ideas you get just as you’re heading into recession and people talk about soft landings and decoupling theses.
The issues in the US banking sector are directly related to the fastest deposit outflows from US banks since 1981, and that is a function of very high interest rates, restrictive interest rates, and T-bills getting to a level of 5%, which was just so attractive relative to deposit rates that you got this behavioural response and a huge deposit beta in US banks.
Now, sometimes rate cycles are short-circuited by financial events. They don’t always end with the unemployment rate gently turning over as we head through the economic cycle, and this looks, to us, very much like a short-circuited rate hiking cycle. Comparisons, I suppose, would be 1984, and Continental Illinois Bank in the US, or 1994.
Subsequent to that, the Fed still hiked once or twice, but within six months you were cutting, and this definitely has that kind of feel for all the reasons I’ve just mentioned. In Europe, you’ve turned an idiosyncratic problem with Credit Suisse into a systemic problem with AT1 subordinated bank bonds as a result of the way they wrote down those bonds last night. And the feel to us is one where, as I said, these problems are directly related to high interest rates, risk aversion and tightening liquidity.
So again, I’d like to thank clients for their patience, because it’s been a long, drawn-out process, but really the speed, the synchronicity and the aggressiveness of the rate hiking cycle is coming home, and it’s doing so, as I said, with one of those short-circuited cycles related to financial events and financial contagion.
We still think it’s early, we still remain defensive, we don’t think this is a buying opportunity in credit. But in rates, I think it puts the debate about rate cuts and which central bank may be the first to cut right on the table and at the centre of discussion. So with that, I might hand over to John who’ll talk about credit.
John Pattullo: I’d just add that we’re always fighting narratives, and we always thought the no-landing narrative was actually crazy and it was in complete contradiction to our business cycle approach. As Jenna said, we did have clients’ patience, and we’re grateful for that. Sometimes it goes so, so fast, and that’s really exactly what’s happened today and over the last few weeks.
I think a very important point is it’s not stylised, and what’s happened in bank funding and recapitalisations causes huge stresses and will change behaviours of individuals and corporates and bank treasurers and bank lending officers and individuals, and that will change the economy.
So the good news is we have been prepositioned really for a hard landing for a long time now, and I suppose we always felt something was going to break. And now, frankly, it’s broken really pretty hard. So we feel we’re pretty well positioned, over nine years duration. Over six and a half years duration contribution of that is in sovereign bonds, and the rest is in quality investment-grade bonds, around 2.4 years, with a tiny piece of high yield, about 0.35 years duration, which is about 7% of the fund in high yield.
We don’t hold any AT1 securities, we don’t hold any corporate hybrids. As you know, akin with our sensible income strategy, we tend to focus on large cap, non-cyclical, reason to exist, quality businesses in investment grade. The bulk of our investment-grade book is actually in the United States. Those businesses are bigger, more resilient and easier and better, easier to analyse.
So we think our book is really very clean. We don’t do exotics, we don’t do esoterics, we don’t do structural products. That’s always been our style, and we’ll always stick to it. So as night follows day, cycles turn, and I think a big turn here, and we feel, going forwards, I think we’re very well positioned from here, and we should expect some really decent capital uplift really on the fund, given that the cycle has turned and now we’re really going down the other side which is going to be tougher for all participants.
I think the final point to make is bonds. Cash has been very attractive and very competitive. That’s exactly… Or even of course short-term treasury bonds have been very attractive against bank deposit rates, which is the point Jenna was talking to, but we do expect rates to come down really quite fast from here, probably a lot more than people think, and even the market thinks.
And then cash rates won’t be so attractive, and then people will want to be extending duration into quality sovereign bonds and quality investment-grade bonds, which is exactly where we’re positioned.
And to be honest, other asset classes will be less attractive. And that’s how monetary policy works. It’s not a surprise to us, it’s just the timing and the pricing of it had quite significant delays in this cycle. But we think we’re through this. It’s peaking out, it’s changing, and we’re well-positioned going forwards. So thank you very much for listening.
Note: Figures on duration quoted in video relate to mid-March figures which may differ slightly to official end February 2023 data shown on slide.
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