Overview
The month of April was relatively calm after the volatile March. The volatility of bonds (MOVE Index) dropped by 35% from its March peak back to its long-term average, and the markets are now pricing-in about two rate cuts in 2023.
Bond returns = capital + coupon
Total Returns from a bond consist of interest coupon received and appreciation (or decline) in bond price. Typically, a bond’s credit spread increases when its riskiness (probability of default) increases, which results in increase in the bond’s yield. When there is a broad-based spike in bond yields (as in case of economic slowdown), the central bank typically reduces the interest rates, which cushion the credit spread increase as seen from Figure-1:
Figure-1: Historically, during recession, treasury yields decrease more than credit spreads widening
Currently, 2-3 years bonds provide yield of about 5.2%, consisting of risk-free rate (treasury yield) of about 4.1% and credit spread of about 1.1%, as seen from Figure-2.
- Source: Silverdale, Bloomberg, Apr’23
- Source: Silverdale, Bloomberg US Agg Index, Apr’23
Figure-2: Short Maturity Bonds provide superior risk-adjusted returns
Hence, even if the economic slow-down results in doubling of credit spreads to say 2.2%, unless the interest rates are not cut by Fed Bank for at least 1.5 years, the investor is unlikely to lose. The chances of such a loss are less than 1-to-10.
Currently, the bond yields are already sliding down as Treasury yields are pricing in (more) interest rate cuts in the coming quarters.
Figure-3: US Treasury yields peaked with market pricing in cuts
Hence, the current elevated yields provide excellent investment opportunity for savvy investors.
‘Profits’ pushing-up inflation
While US headline fell to 5% in Mar’23 (from 6% in Feb’23) and core inflation ticked up to 5.6% in Mar’23 (from 5.5% in Feb’23); as per recent study from Kansas City Federal Reserve Bank, more than half of the inflation since 2021 has been due to price hikes of amounts more than the increase in inputs’ price (resulting in higher corporate margins).
Figure-4: US-non financial profit margins at record levels
- Source: Silverdale, Bloomberg US Agg Index, Apr’23
- Source: New York Life Investments (Mackay Shields)
- Source: Bloomberg, Apr’23
Labour market: cracks but no fissures
Non-farm employment increased by 236k in Mar’23, the lowest monthly gain since Dec’20. The average hourly earnings increased by 0.3%, pushing the 12-month increase to 4.2%, the lowest level since June’21. Thus, the labour market continues to cool down albeit at a very gradual pace.
Figure-5: Non-farm payroll and earnings growth
Bank deposit outflows continue
Fed tightening usually ends in accidents, but accidents don’t change the trend, they only accentuate the trend. The US banks have not passed the deposit holders higher interest rates despite a 19-fold increase in the Fed rates.
Figure-6: US deposit savings rates have not moved materially
As a result, there has been consistent outflow of bank deposits into fixed income funds (specially money market funds) and others. The recent bank failures briefly expedited this pace.
- Source: Business Insider, May’23
- Source: JPMorgan, Apr’23
- Source: Federal Reserve, Apr’23
Lending to slowdown 🡪 Cracks in CRE
Regional US banks face headwinds of higher deposit outflows, NII/NIM pressures, upside provision risks, and more stringent regulations. Hence, they have very sharply tightened their lending standards.
Figure-7: Net percentage of banks tightening lending standards
These banks provide 38% of all bank loans and 67% of all bank loans to Commercial Real Estate (CRE). Thus, the slowdown in lending is starting to impact the economy.
US debt ceiling: distractions
The US hit its debt limit of $31.4 trillion on Jan 19, 2023. The treasury department has been primarily using TGA (Treasury General Account, which is like current account of an individual) wherein they receive their tax collections, to pay for various expenditure. It has drawn over half a trillion from TGA, and effectively neutralized QT (Quantitative Tightening)! The TGA funds will run out by June/July. Thereafter, treasury can (for example) issue one dollar Platinum coin (and effectively borrow a trillion dollar against it). Hence, even if there is a technical default, it would not be a big deal. So, get your pop-corns and enjoy the circus!
Takeaway: High carry in bonds
For savvy investors, high quality bonds with elevated yields provide extraordinary investment opportunity. Our flagship Silverdale Bond Fund (SBF) continues to be well positioned to take advantage of the high carry offered by quality bonds, with 78% high quality Investment Grade bonds and a duration of 1.7 years; yet, having elevated leveraged YTM of 14%, pointing towards higher potential returns for investors. Silverdale Fixed Maturity Funds (FMPs) have provided 1% to 3% absolute returns for the month of April 2023, continue to maintain adequate headroom, and are on track for their envisaged returns.
Thank you for your trust in Team Silverdale.
- Source: JPMorgan Asset Management, Apr’23
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE FUND FACTSHEET FOR APRIL 2023. This document is written for the benefit of and is 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 any Silverdale 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 Silverdale Fund VCC (the “Fund”) or any of the funds managed or advised by Silverdale Capital Pte Ltd., and is strictly for educational purpose 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 based on 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.