This is an extract from an earlier article at Systematic Income Premium.
The ongoing global banking crisis has upended some areas of the income market and led to significant changes in the macro picture. In this article we discuss the consequences of this recent development and highlight income opportunities that it has given rise to.
Key Consequences of the 2023 Bank Crisis
Although this year’s banking crisis is young, it is already possible to make out some of its key consequences.
One is that the two-tiered bank regulatory system has been shown to be woefully inadequate. The irony of this crisis is that SVB was not considered a “systemically important” institution (by virtue of its sub-$250bn of assets) however the FDIC had to issue a “systemic risk exception” in order to backstop its uninsured depositors and prevent, well, a systemic disaster in the banking sector. Expect more regulatory scrutiny on mid-sized banks.
Two, despite the total depositor backstop it’s entirely possible we will see further deposit outflows. Perhaps some depositors don’t have confidence in the backstop or don’t even want to risk getting caught up in the process. Others may just want to move the money into Treasuries, knowing that banks are not passing on the yields they get on their assets to depositors. The BTFP was also set up to be one year long. There is little doubt it gets extended, however people might start to get nervous as we approach the anniversary.
Third, the depositor backstop encourages more risk-taking by the banks. Normally, the banks would be limited in their risk-taking by the chance of uninsured depositor flight. If the depositor backstop is successful, the banks can do whatever they want (or whatever their napping regulators will allow) without fear of another SVB deposit flight. This is a problem for the regulators who now have to significantly improve their monitoring.
Four, the likelihood of a hard landing has also increased for two reasons. This is due to both a further pullback in sentiment as well as increasingly tighter bank lending standards. In other words, banks will likely err on the side of protecting their liquidity than making a marginal corporate loan. This will have a knock-on impact in lower business optimism and less investment. Extending the guarantee on uninsured deposits may alleviate, but will not fully reverse it.
High-yield corporate bond credit spreads have swiftly moved from around 4% to north of 5% while longer-term Treasury yields have fallen which suggests that a greater macro slowdown is on the cards.
Five, tighter lending standards and additional macro headwinds will contribute to disinflationary pressures that are already happening. This should allow the Fed to pause sooner and likely pivot to cutting rates sooner as well than it would have otherwise. This suggests that investors will need to reevaluate holding of floating-rate securities, such as BDCs, bank loan CEFs, floating-rate preferreds and others. Some of these securities have already moved lower in response to broader contagion but may ratchet lower again once the Fed begins to cut.
Six, recent takeovers of Signature Bank by NYCB and of Credit Suisse by UBS have two different implications. On the former, NYCB acquired cherry-picked loans at 80 cents on the dollar. This has obvious implications for the equity of Signature Bank as well as the potential equity payoff for other banks that will be takeover targets. In short, a strong capital position today may be gone tomorrow for banks on the receiving end of the takeover process.
The UBS takeover of CS has direct implications for the AT1 i.e. CoCo bond market which were wiped out in the takeover by the Swiss regulator despite shareholders receiving $3.25bn, an apparent violation of the payment priority (AT1 are higher up the capital structure than equity). Although AT1s were designed precisely to prop up bank capital in a crunch, this fact was conveniently forgotten by some investors. We could see a reduction in confidence in the AT1 sector and this will likely push their prices lower. For the longer-term this increase in risk premium is a good thing and is likely to keep some investors interested in the sector.
New Opportunities Arising
Given the large presence of banks in the preferreds sector, the biggest moves have been there.
In our view it makes sense to split opportunities in the preferreds market into three groups: directly affected by the banking fallout, adjacent to the fallout, and independent of the banking fallout.
Preferreds directly affected by the fallout are regional bank preferreds such as those issued by First Republic Bank, PacWest, Zions Bank, Key Bank, and others. We have some existing positions in these banks which we are happy to hold but we are not adding new capital to these issuers because of a fundamental difficulty in gauging risk/reward.
As we discussed earlier, a regulatory takeover or even a sale of a given bank to another is highly non-transparent and impossible to forecast as it depends on a small group of individuals as well as broader risk sentiment. Either of these actions is also likely to lead to little to nothing left to equity shareholders, including preferreds holders.
This is why we continue to focus on the other two groups. Stocks adjacent to the fallout are those from the TBTF banks such as JPM, WFC, BAC and others which may actually benefit from the loss in confidence in the regional banks. They are also investment banks like GS, MS and custody banks/brokerages such as SCHW, STT and others. The preferreds of these issuers have fallen slightly, likely as a result of investors selling preferred funds (causing the funds to sell assets across the board, regardless of quality) rather than a loss of confidence in these institutions.
A couple of stocks on our radar here are the Citigroup Series K (C.PK), the Morgan Stanley Series E (MS.PE) and Wells Fargo Series Q (WFC.PQ). All three are due to reset to a floating-rate later this year with expected reset yields of near 10%, a significant rise from current stripped yields of around 7%. The first two are trading slightly below “par” in stripped price terms and so would not suffer if they are redeemed while WFC.PQ would enjoy a 7% windfall in case of redemption.
We also see opportunities in preferreds outside of the banking sector entirely. Some of these have fallen as well either due to investors selling funds or due to a general rise in credit spreads.
Investors looking for a diversified preferreds exposure outside of financials may want to consider two ETFs. On the higher-yielding side there is the Virtus InfraCap US Preferred ETF (PFFA) which allocates primarily to Energy and REIT preferreds. PFFA is lightly leveraged which contributes to its higher-beta profile. It has a current yield of 10.93%. A somewhat lower beta option is the VanEck Preferred Securities ex Financials ETF (PFXF) which is overweight Utilities, REITs and Telecom sectors. It has a twelve-month trailing yield of 6.5%.
For investors who want to take advantage of the fallout in banks while maintaining a higher-quality profile may want to take a look at a CEF like the Angel Oak Financial Strategies Income Term Trust (FINS). The fund has two-thirds of its portfolio in bank debt. It has a US community bank focus so it wouldn’t have much if any exposure to AT1s which are European bank instruments. It does hold subordinated bank bonds which are below senior unsecured bonds and so may not hold up as well. As of the latest shareholder report, among the banks in the news, FINS only held one Signature subordinated bond that was 0.04% of its total assets (in pre-crisis market value terms).
As we discussed earlier this banking crisis is very different from what we saw during the GFC. First, unlike the GFC, the bigger and more systemic investment banks are fine this time around in part due to additional regulatory controls that were brought in the wake of the GFC.
Two, the losses on banks’ books are “money good” in the sense that unrealized losses will be reversed if the banks hold the assets in question to maturity. The BTFP program is there so that banks won’t have to realize them. This is in contrast to the GFC where at least some of the losses on bank balance sheets were “real” due to defaults on individual mortgages that were packaged into the securitizations held by the banks.
Finally, there is a self-healing aspect to this crisis as unrealized losses are a function of interest rates. Rates are significantly lower in the last month or so due to poor sentiment and recession fears which has significantly shrunk the amount of unrealized losses on bank books.
None of this is to say that bank sector volatility will quickly subside but it does suggest that investors can have a decent amount of conviction adding capital to appropriate bank and non-bank income securities at the present moment and on further price slides.
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