Chu Toh Chieh is our Senior fund Manager and Co-head of Fixed Income. He has 28 years of fund management experience in this industry, managing various portfolios in fixed income markets, including Asian bonds, Asian convertibles and emerging market debt.
Dawn Leong: What a whirlwind we saw in March in regards to the banking sector. In the U.S., we saw the collapse of Silicon Valley Bank (SVB) and Signature Bank. In Europe, UBS took over Credit Suisse. There is now a huge magnifying glass placed on the balance sheet and liabilities of the banks that could have been affected by the sizable rate hikes we have seen over the past year.
The Federal Reserve (Fed) has been aggressively raising rates in their battle against inflation – this could potentially have resulted in some of the duration mismatch issues we are seeing today. With inflation likely to be above target, growth concerns are now back in the driving seat. Central bankers now are seemingly in a rock and a hard place, battling inflation and growth, as well as rate hiking and credit tightening. So what do you think about the path of interest rate trajectory now and how much more does the Fed need to go?
Chu Toh Chieh: So we have seen the Fed hiking rates from 0.25% from the beginning of 2022 to almost 5% this year in 2023 – that is a huge increase of 4.75%. With such a big increase, we are already seeing the impact on the US economy. For example, US housing numbers are down because they are very sensitive to higher mortgage rates. Also, inflation still remains high.
That said, we have seen the numbers coming down. On top of that, we had the collapse of SVB that would certainly cause US banks to tighten their lending standards. When that happens, the US economy would also contract. From investors’ point of view, we do think the Fed is almost done. They may have one or two more hikes; but beyond that, they will have to start to think about the impact on the US economy. So therefore, we believe that we are at the tail end of the Fed hiking cycle.
Dawn Leong: Let’s zoom in to the second most discussed topic recently, which is the Credit Suisse AT1 bond writedowns, which I believe have taken many investors by surprise. Just to give some background – after the financial crisis in 2008, European banks have issued a bunch of what we call “additional tier 1 capital securities”, or “contingent convertibles” or AT1s or Cocos.
A lot of investors have thought that AT1s are senior to equity in the event of a corporate failure. However, in this case, shareholders would receive compensation while AT1 bond holders would have to forfeit their capital. Naturally this had caused a widespread panic, especially in the AT1 bond market. Are we worried about a widespread contagion and how do we feel about Asian bond markets right now?
Chu Toh Chieh: In the case of Credit Suisse, AT1s were wiped out while the equity holders are still there. So that is very different. After that, various central banks – including the European Central Banks (ECBs), the Bank of England (BOE), even the Monetary Authority of Singapore (MAS) – have all come out to say that the AT1 holders will only bear losses after equity holders get hit.
That is the normal course of action which has given assurance to the market. Now, ever since then, of course, we have seen the impact on AT1 bonds and bond prices have come off. Not only are AT1s lower, the tier two bonds, which is ranked one notch higher than AT1s, also saw their prices weaken. That said, we are seeing some recovery.Given the events, AT1s will take a longer time to recover. On that front, banks will have to wait before they can issue new AT1s. While that may take a while, I believe the broader market has mostly recovered. Therefore, I do not think that there is any real impact on the Asian bond market.
Dawn Leong: So as an investor or a potential investor, how should we be positioned within Asian bonds right now?
Chu Toh Chieh: The interest rate environment has been volatile cause of interest rate hikes that I had mentioned earlier. Taking into consideration the bank failures we saw, it makes sense for investors to stay defensive. We prefer to stay within short duration as we are taking a lower duration risk, and therefore a lower price risk. Furthermore, the yield curve is currently inverted. This means that when you buy the shorter end of the curve, you get higher yield compared to if you were to buy longer. The aforementioned two reasons are why we believe investors should stay on the shorter duration front. Given the potential recession risks, one should think about the impact of such a risk on your credit quality, investment grade bonds. In terms of interest rates, we believe that the Fed is almost at the end of their interest rate hikes, therefore I am not too worried about higher interest rates.
Dawn Leong: To summarize, you think that we are at the end of the rate hiking cycle. But given the huge volatility in the market we have seen, especially in the first quarter, investors should stay defensive and we like short duration and high quality investment grade bonds.
Footnote: All data are sourced from Bloomberg and Lion Global Investors as at 31 March 2023 unless otherwise stated.
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