Overview
“The full effects of our tightening have yet to be felt”
US Federal Reserve Chairman, Jay Powell, Sept 2023
With real interest rates turning positive, long-end yields feeling technical tremors, and corporate earnings revealing cracks, the higher for longer (Fed rates) does not mean several more rate hikes. Consequently, this situation presents a unique opportunity for investors to secure elevated returns, which are comparable to those of equities without the accompanying risks.
Strong economy, widening cracks
Growth: The US economy continues to overshoot expectations, with third quarter growth at 4.9% far exceeding 2023-beginning expectation of 0.30% for FY2023 and much higher than ‘normal’ growth rate of 1.5% -2% p.a.
Inflation: The US headline inflation remained steady at 3.7% YoY in Sep’23, while the core CPI slowed to 4.1% (from 4.3% in Aug’23) as Shetler CPI remains elevated (+0.6 MoM in Sep’23 up from +0.3% MoM in Aug’23).
Jobs: The labor market continues to be tight with 9.61m job openings in Aug’23 (as against 8.92m in July’23) but it is not strong with job growth rate of 0.75% p.a. as against pre-pandemic rate of 1.5% p.a.
Earnings season: While large US banks reported better than expected earnings in 3Q23; it is the smaller banks and MTM losses on bank securities portfolios which are worrisome. US tech giants had mixed showing, with Microsoft and Amazon beating estimates while Alphabet and Meta falling short.
Powell signals to stay on hold in November
“FOMC has tightened policy substantially over the past 18 months, increasing the federal funds rate by 525 basis points at a historically fast pace and decreasing our securities holdings by roughly $1 trillion. The tight policy is putting downward pressure on economic activity and inflation” – Fed Chair Jay Powell.
The current Fed rate of 5.35%, in conjunction with the Fed’s forward guidance and balance sheet reduction, implies the effective Fed Funds rate of near 7%. Additionally, US Treasury Inflation-Protected Securities (TIPS) currently indicate positive real interest rates of around 2.4%, compared to a historical average of 1.5%. Therefore, the necessity for further rate hikes has diminished.
- Source: Fed, Remarks from Powell in Oct 2023
Figure 1: US real rates have moved rapidly higher since 2H22
Short-duration yields are anchored
The short duration yields are influenced by expectations of Fed Funds Rate, and since July’23 have been anchored around 5% for 2-year Treasury. However, in October’23, the 10-year Treasury yields increased by approximately 25 basis points, due to technical factors.
Figure 2: Short end yields remain anchored
- Source: Federal Bank of San Fransico, Oct 2023
- Source: Bloomberg, Data since 1996
- Source: Federal Reserve, Yardeni Research, Oct 2023
- Source: Bloomberg, Silverdale, Oct 2023
Figure 3: Treasury yields compared with Fed Funds Rate
Historically, the 10-year Treasury yields have typically peaked ahead of or in conjunction with the peak in the Fed Funds Rate.
Bond math implies favourable risk-reward
The current elevated yields provide a compelling opportunity for income-seeking investors while protecting against potential downsides because even in case of further 50-100 bps rate hike (or credit spread widening) the investors return would be positive for the year with the benefit from pull-to-par over the bond lifetime.
Figure 4: US Agg Index: Total returns after 50bps increase in yields
Cash is Trap
Sitting on the sidelines can feel like the safer option, particularly when “cash” is offering yields not seen in 20 years. However, cash yields have a tendency to decline rapidly after the conclusion of a rate-hike cycle.
- Source: F/M Investments, Bloomberg, Oct 2023
- Source: Silverdale, Bloomberg, Oct 2023
Figure-5 Lock-in Bond Yields vs Stay invested in cash
Over the past five cycles, the JPMorgan Cash Index USD three-month yield, on average, dropped by 2.2% within 18 months following the final rate increase by the US Federal Reserve. This pattern emerges because central banks typically respond to economic slowdowns with rate cuts. If investors over-allocate to cash, they may face reinvestment risk when cash yields decline.
Open-ended versus FMP
Open-ended funds typically provide much higher diversification, hence a much lower default risk, but bear mark-to-market (MTM) fluctuations. In the short run, over half of the monthly “disparity between the initial yield and the realized returns is predominantly influenced by the change in yield.” In the long term, the fund returns are predominantly determined by portfolio yields rather than MTM. While in case of fixed maturity portfolios “By holding the underlying bonds to their maturity, these portfolios mitigate the mark-to-market risks that stem from interest rates fluctuations and achieve the investor’s cash flow objectives with greater predictability.” For instance, Silverdale Fixed Maturity Fund 2023 is on track to provide target net leveraged return of 7% p.a. as envisaged at its inception in Sept 2020 against the then 3-year treasury yields of 0.15% in Sept ‘20, and Bloomberg’s Global Aggregate Index declining by 19% since Sept 2020.
Strong prospectus for income from bonds
With attractive upside potential, healthy downside protection and an enticing entry point, there is a golden opportunity for investors in fixed income.
For October 2023, the Bloomberg Emerging Markets Asia Total Return Index declined by about 1.25%, while Silverdale Bond Fund NAV declined by 1.22%, and the NAV for various Silverdale Fixed Maturity Funds moved between +0.4% to -1.7%. Silverdale Bond Fund continues to be positioned to take advantage of high carry offered by quality bonds, with 77% high quality Investment Grade bonds, duration of 1.93 years; yet, providing leveraged YTM of 15.1%.
To lock-in prevailing high bond yields over the medium term, we would soon launch a 4-year Silverdale Fixed Tenure Fund.
As always, we are grateful to you for your support.
Assuming long term Fed Fund rates @4% and 5-year Investment Grade FMP returns @10%
- Source: Bloomberg Professional Services Report, Aug’23
- Source: Bloomberg Professional Services Report, Aug’23
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE FUND FACTSHEET FOR OCTOBER 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.