Helicopter View
The inflation spike, super-sized Fed rate hike and haemorrhage of long-dated securities (including equities) resulted in the worst YTD (9 months) capital markets performance since 1970s. As a result, bond markets now provide one of the highest yields in decades. The robust financial sector and strong consumer balance-sheets points to low expected defaults, hence potential outsized returns for bond investors: Volatility is friend of an investor, and bane of a speculator!
Inflation and Rates
The inflation expectations are on decline. The 2-year US breakeven rate is at 18-month low of circa 2.19%, down from a peak of 3.02% in April’22 (that is, the market is pricing about 2.2% average inflation in the next two years).
Still, can the interest rates go higher? While it is possible, the markets have already priced in terminal Fed rates of 4.35% (i.e., further 1.50% of rate hikes). Today, the US corporate BBB bonds yields are higher than S&P500 earning yields (first time in 12 years).
What are the chances of Recession in US?
As per New York Federal Bank, the probability of recession in August 2023 is 25% (refer to Figure-1).
Figure-1: Probability of US Recession
As per Atlanta Fed, GDP nowcast the real GDP estimate for 2022Q3 is 2.4%. Thus, the probability of recession in near-terms are low.
Loan-to-Deposit long rope
The Loan-to-Deposit ratio for US Commercial Banks was 63% in March 2022 (returning to pre-pandemic level of 76% would imply US$ 2.4tn of additional lending (as against quantitative tightening of US$ 1.2tn in next 1 year). This implies the banks have “ability to lend”.
Figure-2: Loan-to-Deposit Ratio of US Commercial Banks
Household Borrowing power: strong
The gross household leverage in US of 1x is in-line with historical levels. However, the net leverage has decreased from over 0.2x to close to nil, due to excess savings during the pandemic period (estimated to be over circa US$ 2.6 trillion).
Low Defaults
For the bond investors, robust corporate and household balance-sheets imply relatively low expected default rates. This is also indicated by current low default rates. Even the high yield default rates are currently below 2%, as against historical average of circa 5%
Figure-4: High Yield default rates have fallen to <2% below long-term historical average of 5% Sept Performance: In-line with indices
Fed chair Powell hawkish comments from Jackson Hole on August 27, continued to rattle the markets. The oversold conditions and drop in energy prices provided some relief in second week of September, which was shattered by August US CPI at 8.3%, which was below July 8.5% but ahead of estimates of 8.1%. The last week of the month was the worst week in over 50 years, triggered by UK’s extravagant fiscal plan. The 30-year UK Gilts hit 5.15% before BOE swing-in to rescue the market. The (European) bank AT1 and Perps dropped sharply, contributing almost one-third of the fall in Sept NAV, resulting in fund performance being in-line with indices with Bloomberg US Corporate Investment Grade Index was down c.6.4% in Sept (YTD -18.7%). Bloomberg Asia Corp Credit Index was down -5.1% (YTD -19.7%).
The Asset Class for Recession
As mentioned in our August 2022 commentary, historically the best performing asset class, 6 months before and 12 months after the onset of recession has been fixed income (refer to August’22 Commentary).
What should investors do
Time in the market is more important than timing the market, more so for bond investing (which is powered by Pull-to-Par). Given the high prevailing bond yields, the investors are well rewarded to invest into fixed income, further accentuated by Pull-to-Par.
Over the past 10 years, when High Yield bond spreads have exceeded 500 bps, the subsequent 12-months have returned over 10%.
OAS Spread | Next 12 Month Average Expected Returns |
300-400 | -1.42% |
400-500 | 4.03% |
500-600 | 10.42% |
600-700 | 14.43% |
>700 | 21.40% |
Figure-6: High Credit Spreads Implies High Potential returns
The Takeaway
While the volatility continues to be elevated, the prevailing bond yields provide superior risk-adjusted returns, as compared to equities or commodities. Powered by Pull-to-Par, disciplined investors in short duration bonds could enjoy handsome returns.
In our flagship, Silverdale Bond Fund, we continue to be positioned defensively, with 77% of the portfolio being high quality Investment Grade bonds with short duration of 1.61 years, yet having leveraged YTM of 18.59% pointing towards potential higher returns.
In our numerous fixed term funds (FMPs), we continue to maintain adequate headroom, IRS, and actively manage the cash-flows for target returns.
DISCLAIMER
THIS COMMENTARY IS AN INTEGRAL PART OF AND SHOULD BE READ ALONG WITH THE FUND FACTSHEET FOR SEPTEMBER 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 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 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.
- Source: Bloomberg, Silverdale; based on Bloomberg Global High Yield Total Return Index, as at 31st August 2022