Monday Espresso Podcast - 20th March 2023

[00:00:00] Sheldon MacDonald: It is the 20th of March. All the talk this morning revolving around Credit Suisse and what happened over the weekend. Ostensibly what looked like a positive news story, the bailout of the bank, turning into a bit of a negative story with what's going on with some of the bonds that are in issue. Before we get into that, let's bring Danny in.

[00:00:18] Sheldon MacDonald: Danny is the manager of Marlborough Bond Fund. Danny, what's the backdrop to this? Cause there's been rumblings around Credit Suisse for a couple of weeks or even months now.

[00:00:26] Danny Fox: Yeah, I think even to say rumblings around Credit Suisse for the last couple of years following a series of scandals which they were attempting to recover from with a turnaround for the bank.

[00:00:36] Danny Fox: I think the trouble is, is that that turnaround needed a following wind in order for it to be successful and the failures we saw in the US banking system last week caused markets to start looking for the next weakest link.

[00:00:48] Danny Fox: That led to some significant, as we now know, sizable withdrawals from Credit Suisse. Which led to the Swiss National Bank having to step in with a facility last Wednesday evening, for them to call on for liquidity purposes if needed.

[00:01:00] Danny Fox: That got them through to the weekend, but it became apparent that wasn't gonna solve the problems. So a swiftly arranged takeover by UBS was sorted out over the weekend, that should have been a very good solution.

[00:01:13] Danny Fox: I think the key problem here is that they decided to give a return to the Credit Suisse shareholders and then wipe out the additional tier one bonds in the capital structure, which is not the norm in these situations.

[00:01:28] Sheldon MacDonald: Of course, yeah, as we expect in the capital structure, typically when there's risk, equity holders are the ones that suffer the most risk and bonds are supposed to be protected.

[00:01:36] Sheldon MacDonald: Now you mentioned these additional tier one bonds. What are these? We're gonna hear a lot about AT1s in the next couple of days.

[00:01:43] Sheldon MacDonald: Give us the background.

[00:01:44] Danny Fox: So these are bond instruments that were intended to provide additional loss absorption capacity in certain circumstances. When the capital ratios of the bank fall below a certain level, or when the bank actually fails i.e. the equity gets wiped out.

[00:01:59] Danny Fox: In the case of Credit Suisse, neither of those requirements were met, but the Swiss authorities had the option when they are getting involved in a recovery situation to wipe out those AT1s. If they'd done that, that would've been fine because people knew what they were buying, that these bonds were there for this very purpose.

[00:02:18] Danny Fox: The trouble is, is that the fact that they've given a return to the equity holders, although despite the fact that it's below Friday's closing level, there was some return to the equity holders. This is called into question the way that the capital structure waterfall now works.

[00:02:32] Sheldon MacDonald: So a degree of moral hazard there that's been introduced.

[00:02:36] Sheldon MacDonald: Let's talk just about more widely what's been going on in markets. So far it seems that this isn't a systemic issue. Nathan markets last week?

[00:02:45] Nathan Sweeney: Yeah, so I think that is an important point. So it is more of a crisis of confidence in a couple of banks, and it's not a financial crisis similar to 2008, and you can actually see that in equity returns last week.

[00:02:59] Nathan Sweeney: So the markets which had exposure to banks, think the UK, think Europe, they've got high exposure to banks. They were weaker, but interestingly, if you look at the Nasdaq, which is the tech-heavy index in the US, that was actually up over 5% last week.

[00:03:15] Nathan Sweeney: So you are getting some positive returns coming through, and another thing to point out is that actually bond markets performed really well last week. So this is on expectations that central banks perhaps don't increase interest rates as much, and therefore those bonds giving you some really good performance and the bonds which are issued for longer periods or longer duration bonds giving you some exceptional returns last week.

[00:03:41] Sheldon MacDonald: Part of that is around the fact that Central banks have also stepped in to provide a coordinated front, to provide liquidity to the markets, and that again is helping to provide a degree of confidence to markets. You mentioned there at rate hikes, we do have a couple of central bank meetings this week, we did have the ECB meeting last week. What happened there?

[00:04:01] Nathan Sweeney: Yeah, so the European Central Bank came out last week and they raised interest rates by half a percent. Now, this was in line with the expectations. However, a lot of investors thought that maybe the central bank may not increase interest rates at that level given everything that was happening in the banking system.

[00:04:18] Nathan Sweeney: So all eyes this week are gonna really focus on two central bank meetings.

[00:04:23] Nathan Sweeney: We've got the Bank of England meeting and we've got the Fed meeting and the big question is there is will they or won't they raise rates.

[00:04:29] Nathan Sweeney: The Fed is expected or was expected, at least, to raise rates by half a percent. Market is now thinking this might be 25 basis points, if at all, and I think the market now believes that the Bank of England will not raise the interest rates from here, so all eyes will be on that this week.

[00:04:44] Sheldon MacDonald: Danny, from a bond market perspective, as a practitioner, what are you seeing on the, the chance of rate hikes?

[00:04:50] Danny Fox: The markets are currently pricing in almost a 50 50 chance of a 25 basis point raise in both the US and the UK. We think that the likely scenario provided markets don't decline dramatically in the next couple of days, is that the Fed is likely to go ahead with 25 basis points because a failure to do so would potentially indicate that they have more concerns about the banking system which could exacerbate the problems.

[00:05:18] Danny Fox: We, however, think that the UK will probably use this as an opportunity to stay on hold and wait for some further information on the economy because they had been making noises in that direction anyway.

[00:05:31] Sheldon MacDonald: So given all the noise, the concerns at the moment, how worried should we be?

[00:05:36] Danny Fox: We don't think that this is a systemic problem in the banking system. This is a series of isolated incidents. Clearly, if we keep seeing lots of isolated incidents, it could become a systemic system, but we are confident that this isn't a credit crisis like we saw in 2008, and that we will be able to get past these problems once the isolated incidents are dealt with.

[00:06:01] Sheldon MacDonald: Let's hope that's the case. Fascinating times, and we look forward to speaking to you again next week.