Helicopter View: Fixed Income
Whilst we can never be sure of the bottom, we cannot be very far from it. After the first half of 2022 which was the worst half-year since 1865, the markets have recovered in the last few weeks. Today, the majority of fixed income assets yield more than 4.50%, which is in strong contrast to over 15% of the fixed assets universe giving negative returns about 2 years ago. For investors, this is good news because the current yields on bonds are amongst the highest in the past decade. While the price of bonds falling makes interesting headlines, for investors, this represents a good investment opportunity because of P2P (Pull-To-Par) i.e. barring bond defaults, the bonds pay “Par Value” upon maturity. The prevailing higher interest rates imply higher carry for investors.
This is also evident from Silverdale Bond Fund’s NAV appreciation of 4.25% post the recent trough on 15th July 2022 (refer to Figure-1).
Figure-1: Silverdale Bond Fund performance from the latest trough to today (15 July 22 to 26 Aug 2022)
Tactical Move
Having said that, tactically, we utilized the rally to further improve our portfolio quality, increase diversification, marginally increase unutilized credit limits to ride out any further re-pricing of the rate hikes and to be able to opportunistically deploy funds to take advantage of the elevated yields for higher returns for our investors.
Inflation: Higher for Longer
The reason for the tactical move is that we expect inflation to be higher for longer. The key driver of inflation is energy cost. We do not see any near-term resolution to the Russia-Ukraine conflict which could ease the energy situation. Rather, we see the US stopping the release of oil from its strategic reserves at the end of October 2022, providing further tailwinds to energy prices.
The balance sheet of consumers in the US is still very strong (thanks to the COVID-induced circa US$ 2.6 trillion largesse). The US banks’ loan-to-deposit ratio is 60-65 as compared to 90+ at the time of the Great Financial Crisis (2008). Hence, we do not expect any sharp drop in demand. We are actively watching the unemployment numbers, and expect them to decrease in the short to medium term.
Across the Atlantic, Europe is likely to face the worst drought in 500 years. This could force food production in Europe to drop by around 16%. Already, the majority of the Rhine River in Germany has dried up, stalling almost 20% of the German heavy sea traffic. While the French nuclear power stations have reduced power production as water level in the rivers have dropped and the river water is too hot to be used for cooling. Soon, Europe would be entering energy-intensive winter months.
The Asset Class for Recession
Historically, the best performing asset class, 6 months before and 12 months after the onset of recession has been fixed income (refer to Figure-2 and Figure-3).
Figure-2: US Corporate IG Performance around US Recessions
Figure-3: Equity returns before and at start of recessions are weak, especially during deep economic downturns
Hence, from the cross-asset portfolio allocation perspective, it would bode well to consider increasing exposure to fixed-income assets, as already being seen from the inflows into fixed income from pension funds and insurance companies.
The August Action
Given the fall in CPI to 8.5% YoY in July compared to 9.1% in the prior month, the month of August started on a positive note with market expectation of Fed pivot for a lower rate hike(s). However, not entirely unexpected, the last fortnight of August reversed some of the rally and the market catapulted on the last day, following Powell’s speech at Jackson Hole where he indicated interest rates would be kept higher for longer. For the month, 2-year US Treasury rates increased by 51 bps whereas 10-year rates increased by 39 bps. S&P 500 was down 1.76%. The market is currently pricing in 70% probability of another super-sized rate hike of 75bps on the 21st of September taking the Fed Rate to 3.00%-3.25%.
Looking ahead, your fund remains well positioned and agile to benefit from prevailing higher yields and continues its focus on carrying, maintaining its short duration, high-quality bias, and a conservative amount of leverage, in order to deliver superior fund performance in the coming quarters.
Silverdale Bond Fund: Performance
For the month of August, Silverdale Bond Fund delivered a positive total return of 0.67%. Geographically, Chinese, Indian and Hong Kong credits were the key positive contributors, which were partly offset by negative contribution from Russian, French and German credits. Sectorally, Financial, Basic Materials, and Utilities sectors were the key positive contributors, countered by the negative contribution from the Energy sector. We did not have any default/fire-sales in the portfolio. The year-to-date drawdown can be primarily attributed to the increase in rates, spread widening and leverage.
The Takeaway
From a historical perspective, fixed income valuations today look attractive. With recession risk on the horizon, it becomes more attractive as compared to equities (which are likely to suffer PE multiple compression). While further interest rate risk from persistent inflation continues to be an overhang, it is also mitigated by the natural higher carry of the asset class.
Silverdale Bond Fund continues to be positioned defensively, with 77% of the portfolio being high quality Investment Grade bonds with short duration of 1.70 years, yet having leveraged YTM of 15.66%, pointing towards potential higher returns.
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE SILVERDALE BOND FUND FACTSHEET FOR AUGUST 2022. This document is written for the benefit of and being communicated exclusively to Accredited Investors or Institutional Investors as defined under the Securities and Futures Act (Cap. 289) of Singapore. The above commentary does not provide a complete analysis of every material fact regarding the market, industry, security, portfolio or Silverdale Bond Fund. It is not a recommendation to buy or sell any security nor an investment advice. The portfolio holdings, opinions and information may change without notice and the actual results may differ from the said opinions and estimates. The contents of this document, including any narrative does not constitute an offer to sell or a solicitation of any offer to buy the units or any Sub-Fund or class of the of Silverdale Fund VCC (the “Fund”) or any of the funds managed or advised by Silverdale Capital Pte Ltd., and is strictly for educational only. The distribution of the shares of the Fund may be restricted in certain jurisdictions. It is the responsibility of the person or persons in possession of this communication to inform themselves of, and to observe all such restrictions, all applicable laws and regulations of the relevant jurisdiction, including of any applicable legal requirements, exchange control regulations and taxes in the countries of their respective citizenship, residence and domicile. Any subscription for units or shares must be made solely on the basis of the Fund’s private placement memorandum, applicable class supplement) and Subscription Documents (together “the Offering Documents”). Past performance is not an indicator of future performance. The Fund uses leverage and invests in financial derivative instruments. Please refer to the Offering Documents for Risk Factors. Nothing in this document is intended to constitute legal, tax, securities or investment advice or opinion regarding the appropriateness of any investment; or a solicitation for any product or service. Please seek opinion from independent professional adviser before taking any decision based on this document.