Industry Voice: Vanguard - lessons for active credit investors from banking stress

In many respects, recent stress in the banking sector was the result of idiosyncratic issues at individual banks, rather than evidence of a deeper crisis in the sector.

Silicon Valley Bank was a case of mishandled expansion and asset-liability management, as the bank invested funds from its rapidly growing deposits in longer-duration securities without arranging adequate protection against the risk of higher rates. This ultimately sparked fear among its concentrated depositor base of technology sector companies, and a deposit run ensued.

In Europe, Credit Suisse was already in the midst of an attempt to restructure and recover from past governance failures and profitability issues when it became the target of investor fears in March. Swiss authorities were promptly obliged to step in and orchestrate a merger with rival Swiss banking and financial services group UBS.

However, these events are prescient reminders for investors in active credit funds of the inherent risks in the asset class in the more unforgiving environment of tighter monetary policy.

Liquidity under increased scrutiny

First of all, it's important to note that there is a low likelihood that we are entering a banking crisis akin to that seen during the great financial crisis. The global banking sector is in much stronger shape than it was in 2008, with better asset quality profiles¹ and higher excess capital levels², which would serve as a cushion in case of stress.

That said, a degree of distrust in the financial sector is bound to linger after the recent high-profile events, especially as the situation is fluid and risks are elevated amid monetary tightening and a looming recession. The seed of doubt in the banking system has been irrevocably planted and the market is on heightened alert for the next weakest link which might break.

While the higher interest rate environment is generally positive for profitability in the sector, the rapid pace of interest rate hikes by global central banks over the past year will inevitably exert asset quality pressures. As a result, we believe that particular risks that warrant close monitoring include concentrations of niche banks in cyclical sectors (such as real estate and shipping) as well as elevated sovereign debt exposures in some banking systems (such as those of Italy and Spain, for example).

Liquidity metrics are also coming under increased scrutiny. In Europe for example, banks broadly maintain solid liquidity coverage and the quality of their liquidity portfolios is high³. They generally comprise a large share of cash and have relatively contained holdings of bonds measured at amortised cost. Instead, most of their bond holdings are accounted for at market value, which typically gives a more accurate representation of their current value. This can help to limit the probability of large hidden losses. But Credit Suisse also had relatively strong metrics just prior to its forced acquisition by UBS, so investors will likely continue to question regulatory liquidity coverage ratios.

As the events surrounding Silicon Valley Bank and Credit Suisse demonstrated, once the confidence of investors and depositors has been shaken, a liquidity drain can take a bank down very rapidly in the social media age.

Feeling the pinch of higher funding costs

One important consequence of the fallout from recent banking sector events is that—owing to lower confidence in the sector—funding costs (namely the yields on debt issued by banks) have increased, especially for smaller banks and subordinated bond structures⁴. This in turn could make banks tighten lending conditions for the broader economy and potentially bring a recession closer.

It's not just banks who are feeling the pinch of higher funding costs. Since early 2022, thanks to global monetary tightening, money has become more expensive for everyone. In this environment, financially weaker companies will continue to be challenged by the tough financing conditions and a degree of caution is warranted. As a result, we maintain a preference for higher-quality credit bonds in this higher-risk environment.

When money is more costly to access, investors tend to become more discriminating in how that money is deployed, as the cost of losing money is higher. And when investment allocation decisions need to be made, investors are more likely to be wary of riskier asset classes and structures. In particular, investors will require a much higher risk premium for investing in subordinated and contingent convertible instruments within the capital structure, such as additional tier 1 (AT1) bonds. Credit Suisse's AT1 bonds were marked down to zero as part of the bank's forced takeover by UBS. While these are arguably well-established and recognised asset classes, they are also more complex and to a large extent untested in a large-scale crisis.

Focus on fundamentals

As markets head into a potential recession with tightening monetary policy as the backdrop, fundamental analysis and security selection matter more than ever for active credit investors. Amid increasing price dislocation in the credit market, the careful selection of resilient issuers through in-depth research and rigorous scenario analysis and stress testing has the potential to add more value to investor portfolios that are managed on an active basis.

The banking sector events of the first quarter also highlight the importance of understanding the nature of the securities one is buying, beyond the yield and return potential alone. Successful bond investing continues to be about protecting downside risk as much as—if not more than—capturing upside returns.

In riskier environments, active fixed income managers with low fees—like Vanguard—have a distinct advantage. When expected returns are not high enough to compensate investors for risks on the horizon—such as a recession—we can take risk off the table and maintain a more defensive approach.

Competitors may feel pressure to maintain higher risk to offset their higher fees. This allows us to perform just as well as our competitors in the good times - but better in the bad times.

This post is funded by Vanguard

¹A bank's asset quality profile mostly refers to the quality of its lending book. A key metric is the ratio of non-performing loans relative to total loans.

² Source: Vanguard.

³ Source: European Banking Authority aggregate data for euro area and Nordic banks, Risk Dashboard; and European Banking Authority 2022 EU-wide transparency exercise.

⁴ Source: Vanguard.

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