Second Quarter 2023 | Fixed Income Commentary
Published on July 27th, 2023
Investor concerns over “sticky” inflation persisted during the second quarter as core measures of the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE), which exclude the more volatile components such as food and energy, continued to come in well above the Federal Reserve’s 2% target. Core CPI increased by 5.5% and 5.3%,1 and Core PCE increased by 4.7% and 4.6%, for the 12-month periods ending in April and May,2 respectively. Despite sustained inflationary pressures, recent macro-economic data have generally surprised to the upside and demonstrated the resiliency of the U.S. economy. First quarter real GDP was revised up from 1.3% to 2.0%,3 consumer confidence reached the highest level since January 2022, and after declining in March,4 retail sales gained 0.4% and 0.3% in April and in May,5 respectively. Additionally, the labor market remains historically tight6 and measures of household wealth are still high.7 Overall, the economy appears to be strong, which has driven real yields higher8 and contributed to the increase in 2Y and 10Y Treasury yields of 87 bps and 37 bps during the second quarter, respectively.9
In response to above-target inflation, a tight labor market and a strong economy, the FOMC raised the Federal Funds Rate by 25 bps in May, for a total of 500 bps of hikes over a 14-month period.10 Moreover, although the FOMC paused on additional rate hikes in June, the Federal Reserve’s Summary of Economic Projections (released each quarter) revealed forecasts for two additional 25 bps hikes this year, and the chances of a 25 bp hike in July increased to 87% as of quarter end.11
In addition to a resilient U.S. economy, we believe stresses in the banking sector also appear to have moderated in recent months. As mentioned in previous commentary, the banks that failed in March had a significantly higher proportion of uninsured deposits, and less stable deposit bases, than a majority of U.S. banks, in our view. Roughly 88% and 68% of Silicon Valley and First Republic Banks’ deposits were uninsured, and both banks experienced drastic declines in deposits of over 80% and 40%, in the first quarter, respectively. Many of the regional banks we own have over 50% of deposits in account sizes below the $250,000 FDIC insured level, which puts them at lower risk of rapid and extreme deposit loss, in our opinion.12 Additionally, weekly deposit statistics for U.S. banks have alternated between rising and falling throughout the second quarter, leaving them largely unchanged over the past ten weeks (for the period ending June 28) and demonstrating signs of stabilization. In fact, for the largest U.S. banks, deposits have increased in 26 of the past 30 weeks.13 U.S. Banks’ combined borrowings from the Federal Reserve’s discount window and Bank Term Funding Program (BTFP) have also declined from a peak of $165 Billion, just after the failure of Silicon Valley Bank, to $105 Billion as of June 28th; indicating declining usage of the Federal Reserve’s emergency lending facilities.14
We have previously highlighted the potential earnings headwinds in the U.S. financial sector from exposure to commercial real estate, and specifically office properties. While we believe that work from home and office vacancy trends may continue, we view the potential threat posed to banks’ earnings and capital as manageable for several reasons:
- Total office property commercial real estate exposure for any of the largest U.S. banks we own is at most ~4% of total loans.15
- Lease turnover is staggered over multiple years so the impact from lease expirations in multi-tenant properties won’t be felt all at once. Of the $5.6T of commercial real estate held by banks, roughly 20% is backed by office properties, of which it’s estimated that only ~$55-60 billion held on banks’ balance sheets is up for renewal in the next year.16
- Declines in property values don’t necessarily prompt loan defaults. Even if “unrealized” losses indicate that loan values are now equal to the re-appraised value of commercial properties, if rental income covers debt service costs, the property will likely remain performing.17
- Banks can build reserves for future losses ahead of time, effectively creating a capital buffer for potential losses should they materialize. According to the Federal Reserve’s weekly H.8 report, for the period ending June 28th, the largest U.S. banks have increased loan loss reserves by over 16% on a year over year basis.13 While holding excess reserves can weigh on banks’ earnings and equity prices over the near term, it is supportive from a credit perspective to retain capital for future losses.
- Losses from commercial real estate ultimately impact banks’ balance sheets through quarterly net charge offs, which occur over consecutive periods, as opposed to all at once. In fact, in the height of the financial crisis, losses from commercial real estate peaked at just 3.27% in the fourth quarter of 2009.15
As part of an annual check-up on the health of the financial system, the largest U.S. Banks recently passed their 2023 stress tests and demonstrated the ability to handle the following hypothetical adverse economic developments: “The severely adverse scenario is characterized by a severe global recession accompanied by a period of heightened stress in both commercial and residential real estate markets, as well as in corporate debt markets. The U.S. unemployment rate rises nearly 6-1/2 percentage points from the starting point of the scenario in the fourth quarter of 2022 to its peak of 10 percent in the third quarter of 2024. The sharp decline in economic activity is also accompanied by an increase in market volatility, widening corporate bond spreads, and a collapse in asset prices, including a 38 percent decline in house prices and a 40 percent decline in commercial real estate prices.” Further, “Declines in commercial real estate prices should be assumed to be concentrated in properties most at risk of a sustained drop in income and asset values: offices that may be affected by remote work or hospitality sectors that continue to be affected by reduced business travel.”18 Therefore, according to the 2023 stress test results, the largest U.S. banks can handle a 40% decline in CRE values, concentrated in office properties and accompanied by various other negative variables, while maintaining capital above the respective thresholds and continuing to lend to households and businesses.
In addition to easing pressures in the banking sector, we believe credit conditions in the broader corporate market also appear to have improved. In aggregate, investment grade companies’ profit margins, leverage ratios, cash balances and quick ratios from first quarter earnings results were all better relative to the prior quarter.19 Although interest coverage levels dropped slightly from the prior quarter, they generally remain at healthy levels, in our opinion. Overall, we believe the sector’s better fundamentals drove investment grade credit spreads to decline by 15 bps throughout the second quarter.20
Consequently, fixed income returns were relatively flat in the second quarter as the impact from higher government yields was largely offset by credit spreads tightening, in our view. CIP returned 0.3% (gross) and 0.01% (net), while the Bloomberg Intermediate US Government Credit Index, the Bloomberg Intermediate US Corporate Index, and the ICE BofA Fixed Rate Preferred Securities Index returned -0.8%, -0.2% and 1.22%, respectively.21
Looking ahead, we continue to monitor the portfolio for possible risks in the banking sector relating to deposit flows and asset quality. While we expect potential headwinds to bank earnings over the near term, we do not believe the banks we own to be at similar risk of failure as those that fell in March. Proposals for further regulation on capital and liquidity are already underway for large and mid-sized banks with assets > $100 million,22 which we believe to be credit positive in the long run. We also remain selective with respect to non-financial issuers’ credit quality, as we recognize the potential for credit spreads to widen from their currently tight levels. Even so, we view the overall risk/reward of the current yield environment as attractive from a historical context as today’s all-in corporate bond and preferred securities yields are at some of the highest levels they’ve been in years.23
Sources:
1. https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm
2. Personal Income and Outlays, May 2023 _ U.S. Bureau of Economic Analysis (BEA).pdf
3. Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), and GDP.pdf
4. US Consumer Confidence.pdf
5. Monthly Retail Trade – Sales Report.pdf
6. Civilian unemployment rate.pdf
7. Households; Total Assets, Level (BOGZ1FL192000005Q) _ FRED _ St. Louis Fed.pdf
8. Bloomberg: GTII10 Govt Index Function
9. Bloomberg USGG10YR Index; USGG2YR Index Function.docx
10. Federal Reserve Board – Federal Reserve issues FOMC statement.pdf
11. fomcprojtabl20230614.pdf
12. Barclays Research and SP Global Market Intelligence.doc
13. h8.pdf
14. h41.pdf
15. Barclays_Bank_Stock_Outlook_Forecasting_and_Valuation-2023 (1).pdf
16. Global_Outlook_The_case_for_US_exceptionalism.pdf
17. Thinking Macro_ Office CRE is a problem, just not a macro one.pdf
18. bcreg20230209a1.pdf
19. Barclays Research
20. Bloomberg: US Agg Credit Avg OAS.docx
21. Portfolio Accounting System of Axys, an Advent Licensed Product
22. Speech by Vice Chair for Supervision Barr on bank capital – Federal Reserve Board.pdf
23. Bloomberg OAS ICE Bofa Fixed Rate Preferred Securities Index YTW US Corp Index YTW .docx
As of June 30, 2023
