Overview
Interest rate hike impairs ability of corporate and consumers to avail credit, hence slows down the economy. The fastest growth in US nominal GDP, supported by record fiscal deficit, strong labor market and robust corporate balance-sheets, has delayed the full impact of rate hikes. Thus, providing investors rare opportunity to lock-in prevailing high bond yields, before the inevitable downtick in interest rates.
Higher for longer doesn’t mean more hikes
The Fed kept rates unchanged in September but hinted (through dot plots) that rates would stay higher for longer due to strong economic growth and labor conditions. As we mentioned in our June 2023 Monthly Commentary, Fed dot plots have historically been a poor indicator of future interest rates. The Fed uses them to guide market expectations, not as predictions. The Fed is signaling to the market not to anticipate (read, front-run) interest rate cuts.
Figure-1 Average months between last hike to rate cut from Fed
While historically (1968-1995) Fed rate cuts were initiated in about six months after the last rate hike, since 1997 this time gap has averaged over 12 months The Fed rate cuts would be driven by deterioration in economic conditions, inter alia, drop in consumer demand, economic slowdown, idiosyncratic events as systemic failure, etc.
Economy remains strong
As discussed in previous monthly commentaries:
(a) Inflation decline won’t be linear
US headline inflation increased for the second month in a row to 3.7% in Aug’23 (from 3.2% in Jul’23) while the Core CPI declined to 4.2% in Aug’23 (from 4.7% in July’23). Thus, the path to Fed’s target of 2% inflation won’t be linear.
For instance, about 90% of mortgages are locked at very low fixed rates, but the rate of mortgage on buying a new house would be multiple times higher at circa 8%. Hence, the home sales have dropped to the 2010 level, thus constraining the home supply, resulting in elevated house prices. At the same time, US Rents are 1.2% lower than a year ago, the biggest YoY decline since December 2020. This will push down core inflation numbers.
(b) Labor market normalizing at slow pace
The labor market continues soften, albeit gradually. The three-month average non-farm payroll addition is at 150k, with multiple downward revisions to past data. The JOLTs reported showed that Job Openings fell to 8.83mn in July (from peak of c. 12mn in 2022) but remain above the pre-Covid level of c. 7mn.
(c) Growth remains strong (for now)
The monetary & fiscal excess of 2020-23, combined with inflation, has resulted in US nominal GDP growth of 40% from the Covid low in Q2’20, this is the fastest expansion since 1949-52, which in turn has blunted the impact of tighter monetary policy.
Median projection from Fed members
- Source: Apollo, Sep 2023
Figure-2 US nominal GDP since 1960 (in US $ trillion)
- Source: WSJ, Moody’s, July 2023
- Source: BofA, Sep 2023
For Jun’23 quarter the US economy grew 2.4% and remains on track for more than 3% growth for Sept’23 quarter, with consumer spending remaining strong as their borrowing cost is locked at very low rates while they are enjoying prevailing higher interest rates.
Higher bond yields = higher income
Before 2022, investors earned sub 2% interest rates, today they can earn circa 4% in 5-year Treasuries, and double of that i.e. 8%-11% in fixed tenure enhanced return funds. This is almost 5-fold increase in investor income!
Figure-3 Compounding of interest income at higher rate results is substantial jump in consumer savings
92% Active Bond Managers beat Index
Over half of fixed income investors have an objective other than maximizing returns (e.g., Central banks, insurance companies, etc.). Also, unlike equities, bonds “mature”, hence, bond market has high attrition rate. About 20% of bond market capitalization consist of new issuances which are offered at concessional pricing (new issue premium) to drive demand; thus, providing opportunities to beat the indices. Further, active fixed income fund managers can use structural tilts, leverage, derivatives, currency swaps, etc. to generate alpha. Hence, savvy investors are increasing their allocation to active fixed income managers as against passive ETFs and Index funds.
Locking elevated returns, leveraging inverted curve with active risk management
Silverdale Fixed Tenure solutions combine prevailing higher bond returns with relatively lower cost of borrowing (the cost of borrowing for 4-years is lower than that of borrowing for 1-year) to create well-diversified portfolio yielding superior risk-adjusted returns. Today, US represents less than one-third of the global bond universe while emerging market USD Corp universe exceeds $2.5 trillion. An Asian bond manger would be hit by underperformance of China bonds. However, investing in European MREL bonds, with credit ratings similar to Asian bonds, would have offered significantly better risk-adjusted returns. Thus, current higher interest rates provide opportunities to generate significant alpha through active management.
- Source: US BEA, Sep 2023
- Source: JPM Research, Sep 2023
Target net yields of Silverdale Fixed Tenure Funds for 3-4 years
- Source: Charles Schab, Silverdale, Hypothetical Example, Sep 2023
Bonds: Pull to Par
As highlighted in earlier Monthly Commentaries, the initial bond yields have proven to be most reliable indicator of future bond returns. Irrespective of mark-to-market (MTM) fluctuations, a typical fixed tenure fund, provides targeted yields.
Figure-4: NAV of Silverdale Fixed Maturity Fund 2023 against theoretical targeted yield
Higher yields with higher quality
For September 2023, the Bloomberg Emerging Markets Asia Total Return Index declined by about 0.93% and Bloomberg EM USD 1-3-year Index was up 0.27%, while Silverdale Bond Fund NAV was up 0.15%, and the NAV for various Silverdale Fixed Maturity Funds move between -0.25% to +1.06%. Silverdale Bond Fund continues to be positioned to take advantage of high carry offered by quality bonds, with 78% high quality Investment Grade bonds, duration of 1.97 years; yet, providing leveraged YTM of 14.20%. In order to lock-in prevailing high bond yield for medium term, we would soon launch a 4-year Silverdale Fixed Tenure Fund.
As always, we are grateful to you for your support.
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE FUND FACTSHEET FOR SEPTEMBER 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.
- Source: UBS, Sep 2023
- Source: UBS, Sep 2023
- Barring bond defaults
- Source: Silverdale Fixed Maturity Fund 2023, Sep 2023 Factsheet