The collapse of Silicon Valley Bank, Signature Bank, and Silvergate Bank in the United States and the Credit Suisse buy-out in Switzerland have set off warning bells across the broader banking and financial sector. While it appears that the immediate contagion from these failures may have been isolated for now, there’s a growing view that regulatory changes are on the horizon. How could these changes amid the uncertain landscape potentially impact investors over the months to come?
Horizons ETFs spoke with Barry Allan, founder, and CEO of DMAT Capital, a firm that specializes in fixed-income-based investing and the sub-advisor to the Horizons Tactical Absolute Return Bond ETF (HARB), the Horizons Active High Yield Bond ETF (HYI), and the Horizons Active Floating Rate Senior Loan ETF (HSL) for his insights on the ongoing fallout from the recent bank collapse, what opportunities may be found in the bond market, and what fixed-income investors can do now to protect themselves from continued uncertainty.
Q: The fallout from the 2023 bank collapses is going to be quite substantial. What do you think this means right now for the U.S. treasury market, going forward?
In the short term, because the market is so volatile, it is difficult to call. But the bigger picture is that if you’re running any bank in the United States, and you’re seeing bank bankruptcies, which are extraordinarily rare, and the FDIC (Federal Deposit Insurance Corporation) is coming in and guaranteeing your depositors, the first thing you’re going to do is tighten lending standards.
The U.S. Federal Reserve (the “Fed”) reports on lending standards [and] it’s been tightening for a while now. The next one will show probably a big increase in [the] tightening of lending standards, and the U.S. economy runs on credit. It’s probably the most leveraged economy in the world. So, tightening lender standards in an over-leveraged economy that runs on credit will ultimately lead to weaker economic growth and lower inflation. That’s the big picture.
Q: Do you think that this was, a result of gross mishandling? Or do you think this was specifically a result of the increases in inflation?
Well, the increases in inflation and interest rates are the triggers. Why they (the banks) failed is debatable, between management incompetence and regulatory failure.
But to me, I don’t think it was so much a regulatory failure as it was management incompetence. The number one rule of banking is, don’t borrow short and lend long because when your depositors want their money back and (if) you don’t have liquid short-term assets to pay them, you go bankrupt. And that’s exactly what happened. In each of these situations. It wasn’t a credit issue, it was a liquidity issue. And that’s simply a mismatch. The regulators don’t regulate what you can invest in and how you manage your deposits versus your assets, and so on.
They measure how much leverage you can have. The banks weren’t over-leveraged, and they didn’t have loan-defaulting problems, not at all. It’s simple, the depositors wanted their money back and the assets that they had to sell had enormous capital losses because interest rates have been going up for a year. And these banks didn’t seem to do any hedging of interest rate exposure or cut their exposure to longer-term bonds and buy shorter-term bonds, which would’ve been prudent.
My view of it is, it’s more management incompetence than it is a regulatory failure, although there are some degrees of both.
Q: Now that we’re in this position, and it seems SVB is only the tip of the iceberg, as you manage HARB (Horizons Tactical Absolute Return Bond ETF), how are you taking a look at these situations and positioning HARB, going forward?
We’re trading duration much more aggressively because volatility is extremely high. The one thing that I don’t think many people understand is, the liquidity and volatility of the U.S. government bond market, which is the single largest, deepest, and most liquid bond market in the world, at 10 times the size of the equity markets, the volatility is the highest in history.
So, there’s an index called the MOVE Index (Merrill Lynch Option Volatility Estimate Index), that measures the volatility of U.S. government bonds, all the way from two years to 30-year maturities. That index yesterday (March 15, 2023) hit just below 200. And the long-term average for that index is 50.
The U.S. Government bond market is four times more volatile than average, right now, which means that liquidity is the poorest I’ve seen it in 40 years, and the bid-ask spreads are the highest I’ve seen them. Usually, there’s one tick or three cents, one 30-second bid-ask spread in the treasury market, and it’s like 5, 30 seconds, right now. So, there are significant impacts.
The liquidity and the functioning of the risk-free rate become the pricing mechanism for all corporate bonds and corporate credit and loans. The risk-free rate drives the equity risk premium or the multiple in the equity market. So, this has a huge impact on all parts of the financial market, and the U.S. Treasury market is in distress, right now.
Q: In terms of seeing a peak in rates, do you think that’s come, in your opinion?
I think the peak in rates is past us. The 10-year U.S. bond yield got to just over, I think it’s 434 intraday, last year. We got up as high as maybe 412, this year. Now, we’re around 355. My range for 2023 would be 290 on the downside and 410 on the upside. And we’ve hit the upside. And the downside is probably later in the year.
But interestingly enough, in the middle of all this volatility, we’re right smack in the middle of the range at 355, maybe slightly above the midpoint. And that is logical to me, because the volatility is so severe, and the uncertainty is so high, if nobody knows what to do, they go to neutral. And a neutral yield for the 10-year treasury is right around 350, 355, which is exactly where it’s trading, today (March 16, 2023).
Q: Obviously, investors are very concerned, as they should be to a degree. When it comes to a fixed-income portfolio, what do you think investors can do at this point to prepare for consistent volatility, and possible changes as we’re in an unprecedented environment, right now?
There are two things that I highly, strongly, recommend. One is that you have active management. The more volatile it is, the more dangerous passive investing is because if you have a passive investment, the human tendency is to sell that investment right at the bottom when your fear level is the highest. High volatility means, one: you need to have active management,
And two: you need to be able to hedge and go long and short. And we do both of those things. We actively trade portfolios. And if we get to a period where we just don’t know which way it’s going to go, then we short government bond futures against our long positions to neutralize the risk and bring the volatility down materially, to where we’re comfortable with it.
Q: Going forward, are we looking at a broad reset due to the over-inflated market? Now that we’re seeing large bank collapses, what is your key takeaway from the last week of events?
I’d say the key takeaway is that the Fed’s been raising rates for a year. They’ve raised them faster this year than they ever have in history, hence the volatility. What happens after large increases in interest rates, almost 100% of the time, is a recession. And when you have a recession, you have lower equity prices and wider credit spreads.
We’ve broadly avoided credit exposure in HARB, where the vast bulk of all of our competitors are investing for yield. And when they invest for yield, they buy corporate bonds and particularly high-yield corporate bonds. In the last year, the yield on the high-yield market has gone from below 5% to above 9%, which has created significant capital losses we have not experienced because we’ve avoided specific exposure to credit risk — which I think is only going to get worse.
The critical thing is, you need active management of duration, and you have to avoid credit exposure until the Fed has actually started cutting rates.
Q: To wrap up, is there anything that you want to speak on regarding the bond market or the potential actions of the Fed related to inflation?
Sure. The one thing that history shows extremely definitively is the Fed is always late. They were late to hike rates, severely late, and therefore, had to go much faster than they normally would. In most other rate-height cycles, they [the Fed] went 25 basis points at a time over two- to two-and-a-half-years. This time, they were going 75 basis points at a time. After next week, if they raise rates, we’ll have raised rates 500 basis points in a year when, historically, it would take them two- to two-and-a-half years to do that.
There are going to be consequences to the economy. And what you also have to realize is, the lags of monetary policy this time could be different, but historically, is 12 to 18 months. And I believe, actually, today (March 16, 2023) is the one-year anniversary of the first rate hike that they did. So, if you believe in a 12 to 18 months lag to the economy, the rate hikes haven’t actually hit the economy yet. And there are 500 basis points of rate hikes to hit over the next 6 to 12 months.
For those in the “no-landing camp”, that is an extraordinarily optimistic view of the economy. And given that the first thing to break was bank failures, which is extraordinary, it’s possible that the downturn in the economy is much more severe than the mild recession, or no recession, that is the consensus view in the equity market, today.
I think that there’s a very large rally in the treasury market coming, a significant selloff in credit markets. And at that point, the credit markets will be normally cheap, as they are in any recession. It doesn’t really matter what the economy does or what the default rate actually ends up being, it’s what the market anticipates that to be and how much more we can sell off.
The high-yield market yields just over 9% today (as at March 16, 2023), but I think we’ll get to 11%, maybe 12%, I’m not sure, but definitely double digits before the credit markets bottom. So, that means that there are still double-digit negative returns to come in the high-yield market. And so, I think that there are definitely negative returns to come in the investment grade market.
President, CEO and CIO, DMAT Capital
Barry Allan is the President, CEO and CIO of DMAT Capital and has more than 38 years of industry experience running investment mandates involved in the full spectrum of the fixed income world, from Government bonds, investment grade bonds, high yield bonds and distressed bonds. Prior to founding DMAT, Mr. Allan founded and built Marret Asset Management, a full-service asset management firm, which he left in 2019. Mr. Allan has also held increasingly senior positions with Altamira Management Ltd., where he managed a wide range of global fixed income mandates, and Nesbitt Burns where he was a proprietary trader, Director, and head of fixed income derivatives.
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