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COCKROACH theory refers to the belief that problems affecting one company may indicate similar problems with other similar companies.
After the collapse of California’s Silicon Valley Bank (SVB), the market and the media are on the lookout for more cockroaches.
The good news is that SVB was an unusual cockroach. The bad news is that other creepy crawlies lie in wait.
Two main issues led to SVB’s fall.
The first was an unusual decision not to hedge interest rate exposure or mismatch between its assets (long-dated fixed income instruments) and liabilities (deposits).
Most banks face this mismatch. Few would leave it unhedged.
Bloomberg’s US Treasury index returned -12.3% in 2022. This gives an indication of the mark-to-market damage that would have hit SVB’s long-dated fixed income assets.
The second factor was the concentration risk in its customer base.
The Silicon Valley tech sector formed almost the entirety of the bank’s borrower and depositor base.
Ultra-low interest rates going into and coming out of the pandemic were a huge boon to this sector.
At the time, money was virtually free and poured into high-growth sectors hungry for returns. But by the end of 2022 – after 425 basis points of interest rate hikes – that was no longer the case.
Higher discount rates needed to be applied to potentially speculative future earnings in the sector.
All at once, SVB found its customers calling on their deposits.
The need to satisfy these liquidity demands caused SVB to start realising some of those steep mark-to-market losses in their assets.
SVB is the 16th largest lender in America, but its $200 billion of assets still sat below the $250 billion threshold at which banks need to report unrealised losses.
This helped hide the stress before a classic run on deposits in early March.
There could be other lending institutions with similar red flags, but the bank’s problems were largely self-made.
Many regional US banks go under every year.
Most often, it is due to the poor quality of their loan books. Not because of poor risk management.
That is perhaps the most heartening takeaway from the SVB crisis.
Unfortunately, other risks have been uncovered by the bank’s collapse.
Here are the main lessons:
The first is that easy money is a thing of the past.
The SVB crisis reminds us that the promise-heavy tech sector needs much more diligence now that money-good T-bills pay between 4.5% and 5%.
Similarly, in Australia cash and near-cash investments yield 4% or more.
This naturally pushes up the bar for going further out along the risk curve and down the liquidity ladder.
When money was virtually free, illiquid and opaque investments such as private debt and equity seemed attractive.
Just as had been the case with SVB until now, unrealised losses within these investments have yet to come to light. That flood of money is reversing.
A second risk is highlighted by the mortgage-backed securities (MBS) losses on SVB’s asset portfolio.
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Mortgage-backed securities allow investors to own part of a bundle of home loans that have been packaged together.
Interest rates were not the only blame factor here. So was the quality of the underlying assets.
Like clockwork, a global synchronised housing downturn is following the synchronised global rate hiking cycle.
Australian credit portfolios heavily invested in illiquid residential mortgage-backed securities (RMBS) face significant hurdles this year.
The value of RMBS portfolios will be affected by the house price correction we’re already experiencing, as well as payment delays from stressed borrowers.
In addition, the RMBS issued by non-major banks are of poorer quality, leading to more accidents waiting to happen.
As Pendal’s senior credit analyst, Terry Yuan, says: “Set-and-forget credit portfolios often rely on the AAA rating of RMBS to raise the average portfolio rating of their holdings, giving them more room to veer into the low-BBB space.
“Both ends of the ratings spectrum will experience a lack of liquidity should something go wrong”.
That is not what true fixed income is supposed to feel like for the end investor.
The third risk unveiled by the SVB crisis is that of information. Unlike the GFC, and thanks to technology, rumours can become truths in the space of a few tweets.
The reality is that SVB depositors are likely to be made whole. The shame is they could have got there without going through this mess first.
Faced with panic, with fear spreading like wildfire, it was individually rational to “sell first and ask questions later”.
This will happen to other institutions as well, leaving the biggest and safest of lending institutions to benefit from the fall-out.
SVB’s failure reinforces our investment views for 2023.
We thought this year’s set-up for bonds looked good even before this most recent crisis surfaced.
The trend of cooling inflation will continue to play through.
The SVB collapse highlights the need to hold a true-to-label fixed income allocation in your portfolios – if only for insurance.
Over the past week, 10-year Commonwealth government bonds rose in value by more than 2.25%.
Portfolios exposed to that move would have felt cushioned against a 2.5% hit to Australian equities over the same period.
Our patience on credit should be rewarded.
Since the third quarter of 2021, we have held a defensive stance in our credit and income portfolios, favouring quality and liquidity over stretching for that extra bit of yield or spread.
We have also been long-time abstainers from RMBS.
Their valuations did not reward us when money was near-free, and the illiquidity they face does not make them attractive now that cash rates are approaching 4% in Australia.
Floating rate senior unsecured paper from our major banks, on the other hand, are a safe place to bias our credit allocations towards.
Amy is Pendal’s Head of Income Strategies. She has extensive experience and expertise in emerging markets, global high yield and investment grade credit and holds an honours degree in economics from Cambridge University.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2021 the team won Lonsec’s Active Fixed Income Fund of the Year Award. In 2020 they won the Australian Fixed Interest category in the Zenith awards.
The team oversees some $20 billion invested across income, composite, pure alpha, global and Australian government strategies.
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Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management.
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