Macro Backdrop
February initially started strongly for risk assets, following a number of central bank meetings which were interpreted as being less hawkish. However, as the month went on, several macroeconomic numbers seemed to suggest that inflation might be more persistent. As such, we saw some weakness in risk assets and government bond rates moved higher, as demonstrated by the UK 10-year Gilt which went up close to 50 basis points (bps) to more than 3.8%. Financial markets might have got a bit ahead of themselves. However, we still believe that we have only seen the first leg of the recovery for our securities, and that during the year we should benefit from the high income we are receiving, as well as seeing valuations go up.
Valuations and Fundamentals
Spreads widened during the month, and this explains the small negative performance we observed. It is important to note that spreads onsubordinated debt of financials are still significantly wider than they were one year ago. We have been through most of the Q4 earnings season and the credit fundamentals of financials remain strong, in our view. For banks, we have continued seeing the trend of increasing net interest income (NII), as banks benefit from higher interest rates. This has outweighed any increase in non-performing loans (NPLs) resulting from the macroeconomic uncertainty. For instance, for HSBC we saw a 38% increase in revenues, mainly due to a higher net interest margin year-on-year that increased by 55 bps to 1.74%. We also saw a very small increase in expected credit losses, but once again this was more than offset by the higher revenues. As such, we believe the fund is well positioned to recover the downward moves of last year. Moreover, banks and insurers are some of the only sectors that benefit from higher interest rates. Finally, any increase in NPLs due to a recession should be easily manageable which is not necessarily the case for corporates – where default rates are expected to increase. In the past, the fund has tended to recover from a drawdown within the next 12 months. We believe the end of the drawdown was in October last year, and as such expect our securities to perform strongly going forward. As stated above, we believe we have only seen the first leg of the recovery. The high income we are receiving will support performance going forward.
Subordinated debt
We are capturing high income, with many securities still yielding within the 8-9% region. Spreads on subordinated debt are still wider than a year ago, and as such we believe the fund should benefit from price recovery going forward. We also observe part of the subordinated debt market is still pricing extension risk, in spite of the fact that additional tier 1 (AT1), restricted tier 1 (RT1) and corporate hybrids are perpetual bonds which have call dates and a strong track record to be called at first call date. We thereforebelieve that extension risk is still overstated. During risk-off environments such as in 2022, callable perpetual bonds tend to reprice to maturity, creating a double-negative effect on prices. However, the opposite is true too, ie when markets begin to normalise, spreads of those bonds start to tighten, leading to a repricing to next call date and sequentially creating a double-positive effect on prices. This has started happening, but there are still a number of bonds pricing extension risk, and as such we believe they should benefit as valuations tighten.
