SVB: are fixed income defaults set to rise?

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The failure of US-based Silicon Valley Bank (SVB) could mark a rise in corporate default rates, yet a wider retreat from loose monetary policy has improved bond sector prospects as markets normalise, according to managers at Newton and BNY Mellon Investment Management.

The recent collapse of SVB sent shockwaves through global markets already grappling with high inflation, rising interest rates and geopolitical uncertainty against a backdrop of war in Ukraine and simmering Sino/US tensions.

Major market volatility in response to SVB’s failure saw US bond yields post their biggest drop since the global financial crisis in 20081 on March 13 as investors sought shelter from swirling market volatility. While US regulators took over the bank, markets remain uncertain amid fears of wider impacts on the banking and technology sectors.

Newton Investment Management head of fixed income Paul Brain believes a long period of low market default rates may now be over. The era of quantitative easing (QE) and unusually low interest rates which helped support this, he contends, nurtured a “broken system” of rising inflation and “bad business models kept afloat by cheap money” which could ultimately give rise to a wave of market defaults.

“Flock of canaries”

Investors are speculating about whether the SVB case is a so-called ‘canary in the coal mine,’” he adds. “It wouldn’t surprise me to see the emergence of some others or even a flock of canaries as companies and markets adapt to the end of QE and corporate defaults rise. The more leveraged companies are the less wriggle room they will have to adjust to rising interest rates and other shifting economic factors.”

Against this backdrop, Brain has particular concerns about high yield and other fixed income assets underpinned by highly leveraged companies.

Economic slowdown, stresses in leverage because of the removal of the cheap money which had underpinned could lead to more defaults. Looking ahead we expect the high yield and leveraged sectors to underperform as we go through this period of financial stress and await a future change in the direction of interest rate moves and the wider market outlook,” he adds.

Market optimism?

Despite these difficult market conditions, Brain believes prospects could improve for sovereign bond markets as global economies rebalance and investors reconsider their options.

Even before the SVB problem developed we felt bonds were back as they are offering a decent income. After a difficult 2022 we are now back to seeing a healthier inverse correlation between risk and safe haven assets.

Against this backdrop, we believe US Treasuries and other government bonds may perhaps prove a more attractive place to head towards as market uncertainty persists, though it will remain imperative for investors to pick their issuers carefully.”

BNY Mellon Investment Management chief economist Shamik Dhar supports this analysis and hopes a wider market shakeout as economies retreat from QE could bring a more robust trading environment and more balanced valuations.

Despite recent spikes in volatility a world where bonds are yielding, say, 2-3 per cent is a far more rational place to be doing asset allocation than the one we have become more used to since the global financial crisis,” he says.

Commenting on the SVB crisis and wider market risk, Dhar says he believes some potential default related shocks were almost inevitable given the current shifting nature of markets and withdrawal from historic central bank support markets have seen since the GFC.

We have been through a very unusual 15–20-year period where interest rates were very low and money has been very easy to access. Institutions that developed business models on the assumption that those conditions would persist indefinitely risk being caught out by rising interest rates and inflation and may well find themselves in trouble as we are starting to see,” he concludes.

1 Reuters. Analysis: SVB collapse unleashes Treasury volatility, whiplashing investors. 14 March 2023.

GE1350954 Exp: 15 June 2023

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