Bond landscape: European banks, USD and SGD bonds

WE expect the eurozone economy to weaken and enter into a recession in 2023, with lower economic activity and higher prices hurting European banks’ asset quality. Non-performing loans have stayed fairly resilient but the European banks have yet to fully provision against higher credit risk in their loans. We expect default rates to rise in 2023 as economic activities contract further and loan-loss provisions increase.

Thankfully, net interest margins due to higher global interest rates are expected to continue to support bank earnings this year. On the other hand, the majority of the losses are expected to come from investment banking and higher provisions for loan loss.

With the median Common Equity Tier 1 (“CET1”) ratio for European banks reaching 14.74 per cent, the banks remain well-capitalised currently. CET1 ratio had previously dropped from 2021 (Figure 1) with higher credit risk-weight assets (“RWA”). But it still saw overall growth compared to the previous years as banks continue to ensure they are well-capitalised after the 2008 Global Financial Crisis. As of 3Q22, European banks maintain a significant buffer over their regulatory CET1 requirements.

We see higher extension risks in Banking Contingent Convertible (“CoCo”) bonds, such as Additional Tier 1 (“AT1”) and Tier 2 (“T2”) bonds. Previously, the economical practice was for banks to exercise the call on the CoCo bonds on their call date and replace them with a similar instrument, due to a lower interest rate environment. However, with rising interest rates, refinancing has become significantly less economical for European banks.

In the European AT1 space, the European Central Bank is considering limiting the call on AT1 bonds if it is uneconomical for the bank; the implementation would result in fewer calls for AT1s on their call date. However, we observed in 2022 that most banks have gone ahead and called their AT1s despite being uneconomical for them. Among SGD CoCo bonds, most AT1s remain economical for the banks to replace with a similar new AT1 bond, but spreads still have room to widen and cause refinancing to be more costly. Thus, we prefer AT1s with higher reset spreads to mitigate extension risk in these bonds.

USD bonds outlook

Sticky inflation is a result of excessive quantitative easing in the past, rising commodity prices, and higher wages, combined with supply-side pressure brought by deglobalisation. This is structural inflation that the Fed may find difficult to tamp down via rate hikes over a short period. We believe inflation will be higher for longer and interest rates will not decrease in 2023. To avoid any serious policy mistakes due to excessive tightening, the Fed may be obliged to raise its inflation target.

There have been various signs of economic recession already, including the inverted yield curve coming at around 70 basis points between the 2-year and 10-year US Treasuries, and the huge lay-offs seen across sectors, including Goldman Sachs, Amazon and Micron. These risks could affect the interest rate environment next year.

The Fed has implied that it would like to slow down the pace of rate hikes, while increasing the terminal rate at the same time. Given the current market environment, we expect the Fed will not lower interest rates in 2023. Investors can focus on US Treasuries; we are more bullish on short to medium-term bonds with tenors of one to five years, while longer-term bonds still face higher price volatility.

High investment-grade corporate bonds (A-rated or above) are more attractive and suitable for investors looking for extra yield pickup above US Treasuries, as their yield spread stability is much greater than other lower investment-grade bonds (BBB-rated), should systematic risks arise.

Global high-yield bonds are less attractive as overall uncertainty in Asia is still high, and the bond spreads across Europe and the US are likely to widen in an economic downturn. Investors should take a defensive wait-and-see approach.

SGD bonds outlook

In 2022, we saw fewer issuances in the second half of the year, with a significant proportion of issuances from quasi-sovereign entities. While issuances in 2022 were similar in number as 2021, excluding the quasi-sovereign issuances, the total issuance volume last year amounted to about S$14 billion, much lower than the 2021 volume of S$18 billion. Rising interest rates made debt issuance challenging as issue had to be priced at a sufficiently high rate to attract demand.

Singapore’s forecasted GDP growth of between 0.5 and 2.5 per cent in 2023 hints at an impending global slowdown or even stagflation. With supply chains operating below the pre-pandemic levels, the cost-push inflation is likely to take an extended period to recover until the demand can adjust to the limited supply. This translates to less favourable operating conditions for Singapore companies; some have already highlighted in their 2023 outlook that headwinds are likely unavoidable.

We expect short-term rates in Singapore to continually adjust to the impending Fed rate hikes. We thus favour short-duration SGD SGS (Singapore Government Securities) of between six months and two years, over longer tenors. Shorter-duration bills currently have a higher yield while being less susceptible to interest rate risk.

On the other hand, with interest rates peaking in the second half of 2023, we think there will be more issuances after a long hiatus. Interest rate expectations are likely to become more stable, which makes it easier for companies to issue debt. We favour investment-grade issuers, given their stronger credit profiles.

The writer is a fixed income analyst of the Bondsupermart team at iFast Financial, the Singapore subsidiary of SGX-listed iFast Corporation.