Updated views on the current challenges in credit markets:
The crisis in the U.S. regional banking industry is still highly fluid and uncertainties remain elevated, but over the near term it should be contained to restructuring for a select group of weaker financial entities (e.g. First Republic Bank). There continue to be some negative consequences to the Fed’s fast monetary tightening. Progress is being made at the same time as the U.S. Treasury’s decision to backstop bank deposits together with the Fed’s newly announced liquidity facility helping reassure depositors. The bank assets of entities being restructured are also not expected to create systemic issues or weigh on the overall health of the financial system.
Fiera’s Integrated Fixed Income Team (Fiera IFI Team) is not changing its base case for economic growth but would add that the overall financial strength of U.S. and Canadian banks should enable them to navigate through the team’s expected upcoming economic slowdown. We do acknowledge that the now faster pace of tightening lending standards should generally impact loan growth and economic growth more quickly than previously expected. This should, at the same time, enable the Fed and BOC to limit additional increases in lending rates. As demand continues to slow down and impact consumer spending as well as private investments, inflation should continue on its path to normalization towards levels closer to the target range for the Fed and the BOC.
Discussing our latest view on credit markets in light of the evolution of the recent pressure on credit markets:
- We continue to expect some resolution in the restructuring of weaker financial entities and believe that there will be some increase in concentration risks toward the larger financial entities while also bringing continued strong and increasing regulation that should be supportive for bond holders. We do expect the challenges to asset quality for the larger banks to stay manageable even including purchased assets from weaker regional entities.
- Investment grade credit spreads have now normalized to levels reflecting this economic backdrop and offer interesting entry points for investments over the medium term. Over the near term, volatility is expected to persist as we navigate through the current slowing economic backdrop and potential added noise coming out of the financial sector.
Specific to subordination in credit markets, the recent wipe-out of Credit Suisse’s deeply subordinated AT1 bonds points to continued cautiousness in allocating to subordinated financial entities. We continue to favor stronger entities and continue to ensure that the additional risk from subordination is compensating us well for both the credit risk and the elevated spread volatility relative to senior debt.
We do have specific comments on the Credit Suisse AT1 write-down and the wider AT1 market:
- The full write-down of Credit Suisse’s outstanding AT1 instruments has led to a global repricing of subordinated/junior subordinated financial instruments (incl. LRCN). The write-down occurred even though Credit Suisse was taken over by UBS and equity holders received material compensation for their holdings, i.e. the equity part of the capital structure was not fully written-off prior to the AT1 layer (the latter in theory is ranking higher).
- The incident clearly highlights the risk attributable to these instruments due to the deep level of subordination and regulators’ desire to minimize the burden for taxpayers in case a bank is no longer viable.
- There are also some potential additional negative technical factors in the AT1 segment of the market related to the Credit Suisse wipe-out where there could be decreased appetite for these types of securities over the near term.
- The developments around Credit Suisse (as well as developments around US regional banks, incl. SVB) are idiosyncratic events related to specific events however, we do not expect the same challenges to arise with Canadian banks:
- Capitalization of Canadian banks remains strong with solid buffers against headwinds
- Balance sheets are generally well diversified/we see much less concentration risks than with some of the US regional banks
- Access to funding remains solid and the bank’s levels of liquidity remain healthy
- There are structural differences between Canadian AT1 instruments and Credit Suisse’s instruments which should provide better protection for instrument holders/be less punitive in a worst-case scenario and OSFI has since confirmed that the traditional creditor hierarchy would be respected in a resolution or in case of insolvency.
Key strategy comments on Canadian banks AT1 (preferred shares and LRCN):
Valuation of CAD AT1 instruments has been under pressure in 2023 and could further adjust depending on how the above factors evolve.
- Low reset LRCNs have suffered a widening of approximately 200 bps in 2023 based on the first call date
- Higher reset LRCNs have generally widened close to 75 bps based on the first call date
On a valuation basis, we think the LRCN and institutional preferred with high reset offer the best risk/reward opportunity in the current environment.
Within the $25 bank preferred shares issues, the focus should be on the big 6 Canadian banks only. The Preferred shares with mid and low reset issues currently offer more upside versus the LRCN low reset issues even before tax. Investors should favor bank issues that will reset in mid-2024 until late 2025 as these issues trade at a deeper discount to par.
Preferred shares investors should expect short-term volatility which could exacerbate with further potential outflows. Over the medium term, investors should benefit from the attractive current yield, the tax advantage, and the important upside in future yields as issues get reset with a higher Canada 5-year yield.
Given the above and the time expected over the near term to address the current challenges in credit markets, we continue to monitor markets closely as valuations complete their adjustment. Valuations have started to show interesting entry points for adding to the Investment Grade and Hybrid markets. Assuming we see further signs of improved stability in credit markets over the near term, we would recommend increasing exposure to the Investment Grade market (Including HAB and HFR) but moving in incremental steps for the Banks’ AT1 instruments (Including HPR and HYBR). Volatility is expected to be elevated and bring additional opportunities in Canadian LRCNs, preferred shares and subordinated bonds at attractive valuations focusing on the strongest entities.
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