Monthly Commentaries

March 2023

Economic and investment highlights

Economic, politics and markets

Global Credit strategy

How we did in March: The fund returned between -2.7% and -2.1% across different share classes, compared to EUR HY (BAML HE00 Index) -0.4%, US HY (BAML H0A0 Index) +1.1% and EM sovereign credit (BAML EMGB Index) +1.7%. Performance in March, gross of fees in EUR, was: (i) Credit: -166bps, with -188bps from cash and 22bps from CDS; (ii) Rates: -49bps; (iii) FX: 15bps, (iv) Equity: -29bps and (v) Other: 0bps.

What are we doing now:

  • The fund entered a volatile month of March with a relatively low net credit exposure, and duration at 1.9y. We have used the sharp moves in March to increase exposure and reduce duration. Our view was that the recent banking stress would not trigger a systemic crisis. As a result, we used spikes in credit spreads as an opportunity to add to our exposure cheaply.
  • Net exposure is currently 83%, vs mid-60s% in early Feb. About 15% of risk was added since mid-March. Risk was added mainly via unwinding CDS hedges on spikes.
  • Net exposure has been close to 100% at the peak of the gas crisis last summer, so we have room to add further if spreads widen more.
  • The fund duration is now 1.9y vs 2.2y in early Feb. The reduction took place mainly via shorts on the 2y part of the curve.
  • On the cash book, we added some AT1s at cheap valuations over the second half of the month, but the cash exposure is roughly the same as one month ago.
  • Financials represent 63% of the book, of which 35% AT1s. Most of the exposure is in large systemic banks in Europe.
  • Corporates represent 32% of the book, skewed towards Europe. We hold mostly high-yield names in higher quality sectors (eg Telcos).
  • EM represent 16% of the book, with a focus on local currency bonds in countries where the central bank will be able to cut.
  • Gross exposure in the fund is 157%. Our credit short book is -28%, of which -8% via cash credit and -20% via CDS (-13% index, -7% single name CDS).
  • The blended YTC of the fund is 9.4%, and YTM 8.7%. Credit quality is BB+, on average.

Following the recent moves, YTC vs duration and YTC vs rating screen best in the history of the Fund.

Financial Credit Strategy

March was a tumultuous month for the financial space globally as the risks linked to the rapid pace of Central Banks’ rate hikes came to the fore. The flashpoint was the collapse of Silicon Valley Bank (SVB) which suffered from extreme deposit flight after failing to follow through with a rights issue to mitigate a $2bn loss from the disposal of $21bn securities, predominantly US treasuries. SVB’s collapse unveiled some weaknesses across the US regional banking sector, in part due to regulatory changes a few years ago, and led to c.3% deposit flight across the smaller banks. Subsequent measures put in place by the Federal Deposit Insurance Corporation (FDIC) and US regulators have since shored up confidence across the US banking system.

After reporting a c.35% deposit outflow in 4Q22, Credit Suisse (CS) suffered from ongoing liquidity issues and inevitably had to resort to emergency liquidity by the Swiss National Bank (SNB). Unfortunately, this was not enough to stem concerns and a few days later the Swiss regulator FINMA forced through the sale of the entire bank to UBS for $3bn in shares. As part of the sale, $16bn of AT1s were entirely written-off. Over the past year, we had become increasingly cautious around the short-term profitability of CS’s franchise and accordingly moved up the capital structure, rotating our exposure to Seniors away from AT1s, leaving funds with just c.20bps of the latter.

Understandably, FINMA’s decision to not offer AT1 holders any compensation, in contrast to equity shareholders who even get to share in future upside, created considerable consternation for AT1s as an asset class. Noting the severity of these implications, both the EU and UK regulators swiftly responded by confirming that equity remains the first to absorb losses, and only after its exhaustion would AT1s be required to be written down or converted to equity. This immediately soothed worries around the AT1 asset class, emphasizing the idiosyncratic outcome of CS’s and more broadly Swiss AT1s, and dispelling contagion fears to European, including UK, AT1s.

Performance across European financial credit was impacted by the above turbulent developments in March. Despite a remarkable recovery from the intra-month wides, Senior and subordinated spreads still closed the month 30bps and 60bps wider respectively. On average AT1s fell c.7pts and there was some notable outperformance by national champions as well as structurally superior securities. Unsurprisingly, bank equities were one of the worst performing asset classes, -13% and -25% in Europe and the USA respectively, leaving YTD total returns at +6% and -18%, respectively.

Despite the broad-based underperformance of financials in March, we remain confident around the outlook for the wider European banking sector as we draw no direct parallels from events across both US regional banks and CS to our core holdings. Spreads across the financial space have gapped out to levels not seen since Covid and arguably today the sector is fundamentally stronger given higher base rates. Furthermore, from a technical standpoint YTD issuance is running c.15% ahead of last year’s elevated levels and there is a higher likelihood of AT1s being called than extended over the rest of this year.

Financial Equity Strategy

March 2023 was a historic month for the global financial sector. The failure of two large banks in the US caused widespread concern about the funding stability of the US banking system. Investors ‘shot first, and asked questions later’, triggering a 25% fall in the BKX. Meanwhile in Europe the multi-year troubles that have surrounded Credit Suisse climaxed over a momentous weekend in which UBS took over the troubled lender in one of the largest bank M&A transactions in history. European bank stocks finished the month down 13%.

With calm returning, we can take a step back and assess what has changed and what has not. It is perhaps surprising given the media spotlight on the issue, but overall bank deposits in the US were down just 2% in the two weeks following the failures of SVB and Signature Bank. While unhelpful for a sector already facing funding pressures from deposit migration and higher deposit betas, it should not portend a massive credit crunch that many seem to have been predicting. It also shows the idiosyncratic nature of SVB and Signature which had concentrated and largely uninsured deposit bases (with much of Signature’s recent growth being driven by crypto), characteristics not reflective of the vast majority of US banks. While smaller banks have clearly been hit harder than larger ones with just over 3% deposit outflow for banks outside the top 25, this is by no means a crippling result. Commercial real estate concerns have increased broadly and smaller banks tend to be concentrated in this sector so it is reasonable to expect difficulties for some of these lenders.

But this crisis strikes us as analogous to what we saw post the Russia invasion in February of 2022: an exogenous shock causes a drastic downdraft in which bank stocks fall together with very high correlation, despite there being a clear case for winners and losers. Small banks with the stickiest deposit bases and strongest capital positions now trade at 40%+ discounts to their historical averages even when factoring in various earnings hits likely to come from margin, credit, and regulatory pressures. There has also been fairly substantial collateral damage outside the bank space, with life insurers in particular getting sold down violently despite a highly stable funding base, conservatively underwritten mortgage portfolios, and no exposure to a more difficult regulatory regime. High quality insurance stocks now trade at 5-6x earnings (30-40% discounts to historic averages) and look increasingly attractive.

All this is to say we are finding opportunities amongst the rubble from the cataclysm that was SVB. Fortunately, we came into this event with a very significant cash position. But it is not just the US where we are starting to deploy it. If anything, Europe – for the first time in a long time – is perhaps the simpler place to be investing these days. Although Credit Suisse was a historic transaction, it appears that the indirect aftershocks may be less powerful than what we will see in the US. Indeed, we saw three large European banks gain approval for significant buyback plans in the immediate period around the CS deal, suggesting regulators continue to be comfortable with the capital and liquidity position of the sector. And while US earnings are very likely to be downgraded (more a question of how much), Europe bank earnings should continue to trend in the positive direction – and notably, deposit flows and betas appear to remain well behaved. But it is clear that many of the tourists in this space fled at the first sign of danger, similar to what we saw last year following the war. In fact, futures positioning in the SX7E plunged to 5 year lows during March. We find European bank stocks trading at crisis-level lows both on an absolute and relative basis (6x forward earnings and ~50% of the market multiple), with total payout yields for many well into the double digits. In sum, European banks continue to have strong tailwinds from a fundamental, valuation, and sentiment perspective, and we have used the steep declines in the stocks to add across our highest conviction holdings across Europe.