Highlights – and lowlights – from a turbulent first quarter for bond investors

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Wacky? Topsy-turvy? Turbulent? Pick your adjectival poison. However you describe it, the first quarter of 2023 was a rollercoaster ride for bond investors, who – let’s be honest – should probably be getting used to it by now. Amid Q1’s bank failures and “bailouts-lite,” recession fears and continuing uncertainty about inflation and interest rates, the path ahead for corporate bond markets looked anything but clear. In their April 2023 Corporate Bond Newsletter, the team at leading Canadian institutional investment management firm, Canso Investment Counsel Ltd., deciphered the tangle of first-quarter news to find meaningful insights. Here are the highlights.

To read the full report, please click here.

It seemed like a good quarter at the time

Q1 came in like a lion and went out like a wounded – but still standing – hippo. As the Canso newsletter noted, 2023 “began with swift optimism.” Equity markets were up, credit spreads tightened, and new issues in both investment grade and high yield bonds attracted buyers.

And then March came along, turned out the lights and declared the party over (at least for a time).

The bond market version of “March Madness” kicked off with high-profile regional bank collapses. They began in the U.S. in the second week of the month, with the wind-down of Silvergate Bank, which was soon followed by a run on deposits at Silicon Valley Bank (SVB) and the closure of Signature Bank. Within the span of about a week in early March, the U.S. “had entered a regional banking crisis.” A few days later, jitters bled across the Atlantic to Europe and claimed a global bank – Credit Suisse – as their next victim. On March 19, rival UBS Group AG took over its CS rival for a mere three billion Swiss francs, in a deal facilitated by Swiss regulators.

Understandably, this rattled bond markets. Credit spreads widened in Canadian and U.S. corporate bond markets, ending the quarter higher than where they began, largely due to exposure to bank issuers (especially in Canada, the newsletter noted, where “exposure to the banking sector is much higher at 32.5 per cent relative to 18.2 per cent in the U.S.”).

“Risk-free” risks and wiped-out bonds

SVB’s collapse came after the bank – once a financial institution of choice for the moneyed Silicon Valley tech crowd – posted huge losses on Treasury bonds, which many folks (perhaps even those who ran SVB) believe to be risk-free. Yet as the Canso team pointed out, the long bonds to which SVB was so heavily exposed might be “free” of credit risk, but they are most certainly exposed to interest rate risk.

While rates rose over the past five quarters, the value of the long-dated bonds that SVB planned to hold until maturity plummeted. When depositors began to lose confidence in the bank and withdraw their cash, SVB was forced to sell off its trove of Treasury bonds to raise liquidity. “Suddenly, the unrealized losses on [SVB’s] balance sheet became realized, threatening their capital position,” the newsletter noted. After a proposed equity sale failed to restore confidence and depositors continued the run, SVB shuttered operations.

Enter U.S. regulators, who tried to walk a fine line between preventing a full-scale crisis in the financial system and avoiding the bad optics of bailing out wealthy, irresponsible bankers. Labelling the SVB collapse a “systemic risk” allowed officials to make all depositors whole, whether insured or not, from a special assessment to other banks (not taxpayers). Yet the “rescue” did not protect shareholders, management or – importantly – debtholders. The Canso team expects that the result will be “less than a full recovery for [SVB] senior debt” and “a near complete wipeout” for junior debt.

For some holders of Credit Suisse debt, meanwhile, the situation might be even more remarkable (in a bad way). Swiss regulators “convinced” UBS to take over its rival for a price that was less than one percent of CS’s assets at the end of 2022. (“Nice deal!” the Canso team remarked.) The deal structure preserved value for CS equity, but some debtholders were not so fortunate. The Swiss regulator FINMA wrote down the value of the bank’s convertible contingent (or CoCo) bonds to zero, even though these AT1 securities are usually ranked higher than equity in a bank’s capital structure hierarchy. “It is rare to see securities higher up the capital structure (AT1) being completely written-off without lower ranking securities (common equity) being completely written-off,” the newsletter noted. “But in Switzerland, … the [UBS/CS] offering documents explicitly state that this scenario is possible.”

So, how bad was it?

Maybe not that bad. In the last few weeks of the quarter, corporate bond markets recovered some of the ground they lost amid the bank collapses. “When the dust settled, a renewed appetite for risk and lower bond yields ultimately prevailed over market volatility,” the Canso team wrote.

Outside of bank issuers, credit spreads proved resilient, and bond yields fell. The two-year Treasury yield – considered a key indicator of market expectations for U.S. Federal Reserve rate moves – ended the quarter lower than the then-current central bank administered rate, “implying with increased confidence that rate cuts are on the way,” according to the newsletter. Driven by those moves in government bond yields, investment grade corporate bond indexes ended the quarter with positive returns. Adding buoyancy to bond markets: the fact that interest rates have risen so far that “investors now have yield on their side to provide a buffer while the market attempts to guess when conditions will finally be right for the central banks to relent,” the Canso team wrote.

Meanwhile, risk premiums for Canadian investment grade bonds are becoming more and more compelling, the team added, with spreads now higher than in 2011 or 2016. But perhaps they are not high enough. “A deterioration in credit fundamentals still doesn’t appear to be reflected in the pricing of Canadian investment grade bonds,” Canso noted. “If lower government bond yields are signalling recession, corporate valuations have not gotten the message.”

Still, the newsletter noted that bond markets are “desperately” optimistic that this spring will bring relief from rising interest rates. Also heartening is the fact that “there is once again income in fixed income. And while uncertainty still reigns and financial conditions are likely to tighten further, that, too, may come with a silver lining. “Uncertain and increasingly illiquid markets invariably produce opportunity,” the Canso team wrote, “and that is where our investment focus remains.”

The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Canso Investment Counsel Ltd, which is a member and content provider of this publication.