Asset class returns continued to move in tandem as equities and bonds alike moved higher in Canada and the U.S. But these returns were only available to those who didn’t panic and run for the exits during a rather tumultuous period. And that was before a string of bank failures in March 2023.
“The first quarter was a turbulent period, particularly for bond investors, who endured sharp moves in yields. When the dust settled, a renewed appetite for risk and lower bond yields ultimately prevailed over market volatility,” the team at Canso Investment Counsel Ltd. said in its April 2023 Corporate Bond Newsletter.
“Fixed income markets were carried forward by the impact of falling government bond yields and resilient credit spreads outside of bank issuers.”
Banks in crisis
The spring brought fresh volatility to the banking sector in the U.S. and Europe: first it was Silvergate Bank winding down its operations, which helped trigger the run on Silicon Valley Bank (SVB) and its ultimate demise. Then we saw contagion fear make its way across the Atlantic to ensnare Credit Suisse, bringing about a fire sale to UBS Group AG.
Silicon Valley Bank was the 16th largest bank in the U.S. with deposits of nearly $200 billion, but a whopping 88% of those balances were uninsured. As fear took hold and stakeholders clamoured to get out, their homogenous client base proved to be the “coup de grace” with cash on hand wiped out as word of difficulty quickly spread in the venture capital community that dominated the SVB client base.
While depositors were worried about losing their savings, investors feared their equity holdings could be reduced to zero if insolvency occurred and dumped their shares, which decimated the stock price.
“In an effort to shore up capital, the bank attempted to sell $2.25 billion of equity into the market. Instead of restoring confidence, this frightened investors. The equity sale was pulled and the stock dropped 60% the next day,” Canso said.
“On Thursday, March 9th, $42 billion of deposits, approximately 25% of the remaining total, left the bank. By the following morning, the bank was shut down by regulators.”
FDIC to the rescue
Regulators stepped in to ensure all SVB customers would be made whole — meaning no loss of those huge uninsured balances. Taxpayers wouldn’t take the kind of hit they did in the 2008 bailouts to achieve this outcome for depositors, since any shortfall losses to the Federal Deposit Insurance Fund (FDIC) would be covered by a special assessment levied to other member banks.
But that focus on the ramifications of additional global financial crisis-type bailouts meant this rescue operation focused solely on assisting depositors and did nothing to protect debtholders, shareholders or management.
The clock was ticking for Credit Suisse…and then the bell tolled
Credit Suisse, meanwhile, had been floundering for years, but remained one the largest and most important financial institutions in Switzerland.
The bank took huge losses on the collapses of Greensill Capital and Archegos Capital Management in 2021. Their woes continued in 2022 when leaked information suggested the bank had served a host of criminals, from human rights abusers to corrupt politicians and businessmen, for decades. Then they were found guilty of not doing enough to prevent Bulgarian drug traffickers from laundering money through them.
Multiple scandals and incidents at the bank led to frequent leadership changes, which presumably pulled management’s attention away from day-to-day operations and at least contributed to some of their problems.
A deal was brokered with the result being a full takeover of systemically important Credit Suisse by UBS, Switzerland’s largest bank, and a complete wipeout of Credit Suisse AT1 securities. For most global AT1 securities, including Canadian LRCNs (limited recourse capital notes), a distressed scenario would include both the AT1 securities and the lower-ranking common equity being written down. Even though the offering documents clearly indicated that this scenario was a possibility, it’s not something anyone really expected to come to fruition.
I thought Treasuries were a risk-free asset
A major contributing factor to SVB’s failure was its inability to properly match their assets and liabilities. They were reaching for yield by investing in longer-dated treasuries that possess significant duration risk due to their long-term maturities, which amplifies the negative price impact of rate increases. But, these were classified as held-to-maturity assets, meaning price risk was irrelevant because they weren’t going to be sold. At least, not until they had to be sold.
To shore up their balance sheet, SVB needed to sell assets, which meant selling those long-term Treasury bonds. This could only be done at a loss as interest rates had come up considerably since those bonds were acquired and they could not be sold for anywhere near par value. SVB needed liquidity and so the losses mounted. Suddenly, previously unrealized losses on their balance sheet became realized losses and threatened their capital position to the point of being untenable.
When people talk about risk-free assets, they mean short-term Treasuries, not government bonds with maturities 20 or 30 years out.
A double whammy for lending activity
All this uncertainty led to real fears that these bank failures could seriously impact lending activity in North America and around the world, which was already hampered by steady increases in short-term interest rates throughout most of 2022.
That could accelerate the path towards a recession, as these institutions account for a sizeable share of all lending. In particular, the U.S. regional banks could choose or be required to adjust their lending practices, meaning fewer qualified borrowers and less lending.
Rate cuts on the way?
As markets remain too volatile for some investors, many are recalibrating their forecasts of future central bank decisions, as well as their investment plans.
A lot of investors are looking at more conservative investments, whether that means owning government bonds or ultra-conservative holdings in cash or cash equivalents like money market funds.
“With short term government bond yields above 4% it is not surprising that investors are rethinking their investment strategies and migrating in mass into money market funds,” Canso said.
Whether that also means a path to lower interest rates remains to be seen, and bond markets in Canada and the U.S. advanced in Q1 with government bond yields still the primary driver of returns.
The team at Canso indicated that the 2-year yield on Government of Canada and U.S. Treasury bonds is where some of the fiercest swings occurred, relative to the overnight rate.
“In both cases, yields have now fallen below the central bank controlled administered rate, implying with increasing confidence that rate cuts are on the way,” they said.
For anyone with a variable-rate loan eagerly awaiting word of rate cuts, it’s starting to look like these might happen sooner than previously thought at both the Bank of Canada and Federal Reserve.
Read the full April 2023 Canso Corporate Bond Newsletter here.
DISCLAIMER: 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.
