Overview
‘Fooled by Randomness’ aptly describes strong economic numbers with uptick in headline inflation and 187k job addition, masking sharp drop in non-Shelter core CPI, downward revision of jobs addition by 110k, spike in credit card delinquencies, and sharp drop in credit offtake. In this uncertain macro environment, quality bonds present the opportunity for equities like returns but with significantly lower volatility and risks.
US inflation: Mind the gap
As mentioned in Silverdale Monthly Commentary June 2023, the headline inflation for July’23 nudged higher, at 3.2% (as against 3% in June’23) due to the base-effect and energy prices; while the core inflation ticked down to 4.7% (from 4.8% in June’23) due to the lagging effect of shelter. Without the lag factor of shelter, the core CPI would be at 2.6%.
Figure-1 Housing components of CPI lagging market observed rent measures by 10 months (%)
As detailed in Silverdale Monthly Commentary July 2023, inflation is likely to remain stuck above the Fed’s target of 2% for a long period of time. Therefore, investors will do well to look beyond the gyrations in inflation, and position the portfolio to seize the prevailing high yields.
Labour market: cooling down
The US Labor Department reported 187,000 jobs addition in August’23, but gains for the previous two months were revised lower by a combined 110,000. The unemployment rate climbed from 3.5% to 3.8%, to reach its highest point since February 2022. Yet, at 1.5 jobs for each person (peaked at c. 2x in 2022), it continues to be much higher than pre-pandemic level of circa 1.2.
As 736,000 people re-entered the job market, the labor force participation rate hit 62.8%, its highest level since the start of the pandemic in February 2020, yet below the pre-pandemic trend.
Fed uses Jackson Hole to signal the market
In his speech at Jackson Hole, Fed Chair Powell acknowledged that the current monetary policy is “restrictive”; however, added that inflation in the non-energy and non-housing services sector remains persistent due to tight job market; thus, kept the door ajar for potential rate hike. Thus, Powell signaled the market not to prematurely price the rate cuts (for details, please refer to June 2023 Commentary). This is good news for fixed income investors, as bond yields peak before the last Fed rate hike.
Missing Recession
Increase in interest rate increases the cost of borrowing, that is, reduces the affordability to borrow, leading to reduction in economic activities, resulting in economic slowdown / recession. During the pandemic, the corporates as well as consumers borrowed heavily at the then prevailing ultra-low interest and locked their borrowing cost. Hence, despite Fed rate hikes, the corporate interest burden continued to be low.
Figure-3 Broken relationship between interest rates and corporate interest payments (%)
Similarly, only 11% of outstanding household debt carries floating coupon, that is, 89% of household borrowings are not directly impacted by Fed rate hikes. Therefore, consumer spending continues to be robust.
As these low-interest borrowings mature next year, these dynamics will change. As detailed in the previous Silverdale Monthly Commentaries, the cracks in balance-sheets are steadily growing wider, as seen from slowdown in credit offtake and uptick in credit card and auto-loan delinquencies.
Figure-6 Consumer delinquencies are moving higher(%)
Hence, it is not that recession is ‘missing’, it is that the economic slow-down is slow in manifesting. In case of an economic slow-down, the best performing asset class is fixed income.
If you don’t lose money, you make money
For investors to make money by investing into equity, the equity needs to appreciate. For investors to make money by investing into bonds, the bonds need not appreciate; even if the bonds’ prices decrease, it does not matter because bonds pay par value on maturity. Thus, bonds provide much higher certainty of income as compared to equities.
Bond coupons are the cushions
The interest paid by the bonds (i.e. coupons) act as cushion to the interim bond price volatility. For example if a 3-year bond is providing 5% yield, and if the interest rate increase by 0.50%, the bond price will fall by about 3*0.50% = 1.5%. However, as the bond is paying 5% coupon, the investor will get 5% (coupon) less 1.5% (mark-to-market hit) = 3.5% (positive) return for the interim period. On maturity, investor will get par value irrespective of the interim market price of the bond. Thus, the prevailing high yields provide huge cushion to bond investors.
- Source: DataStream, SocGen, Aug 2023
- Source: Moody’s, Washington Post, Aug 2023
Except where the issuer becomes bankrupt
Other things being equal, assuming linear relationship
Quality is King
The bond yields constitute primarily of (a) risk-free rate (represented by interest paid by Government bonds), and (b) risk-premium of the bond issuer (represented by CDS of the issuer). In case of an economic slowdown, net profits of companies drop; hence, the chances of poor-quality companies defaulting increases. In such circumstances, the central bank lowers the interest rate (i.e., interest on Government bonds comes down) and there is flight to safety towards high-quality bonds. Therefore, in case of an economic slowdown, quality bonds become relatively best performing asset class.
Capture higher yields with higher quality
For August’23, the Bloomberg Emerging Markets Asia Total Return Index declined by about 1.9% and Bloomberg EM USD 1-3-year Index was flat, while Silverdale Bond Fund NAV was down by 2.6%, and the NAV for various Silverdale Fixed Maturity Funds were -0.25% to being unchanged. Our flagship Silverdale Bond Fund (SBF) continues to be positioned to take advantage of high carry offered by quality bonds, with 79% high quality Investment Grade bonds, duration of 1.99 years; yet, providing leveraged YTM of 14.4%, pointing to higher potential returns to investors. In view of the prevailing elevated bond yields, Silverdale Fixed Maturity Fund October 2026 is still accepting subscriptions. Thank you for your support.
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE FUND FACTSHEET FOR AUGUST 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 an independent professional adviser before taking any decision based on this document.
Baring default by the bond issuer
Credit Default Spread
Economic slowdown means the sales of companies fall; when sales drops, the net profit of the company falls at a higher rate (since almost all companies have fixed costs). When net profit falls, earnings per share (EPS) drop, when EPS drops, the equity share price falls.