Hello and welcome to the RBC Global Asset Management Navigator Podcast. My name is Bethany Jessen, client portfolio manager with RBC Global Asset Management. Today I'm joined by Andrzej Skiba, head of Blue Bay US Fixed Income at RBC Global Asset Management. And today's episode of the Navigator Podcast, we're going to discuss our view and outlook for US fixed income markets in 2023.

Hello, Andrzej. Thank you for being here with us today.

Hello, Bethany. It’s my pleasure to speak to you.

We look forward to getting your thoughts on what has already proven to be an eventful start to 2023. I wanted to address with you some of the questions and concerns that are on top of mind for clients today. And I'd like to first start off with some of the more recent volatility that we've seen enter here in the market in March.

Obviously, we've been having lots of conversations with clients on the topic related to the banking and financial sector issues. Investors were caught off guard with some of this recent banking stress. This left clients to really wonder what exposures they have, what risks are in their portfolios. Will there be a contagion effect? And is this going to be like the last financial crisis?

How would you respond to those clients?

I think that's a brilliant question and it's at the heart of concerns and worries within the market. Can the volatility that we have experience in financials over the recent weeks spill over into something even more ominous? And I think the first thing to mention is the fact that we will be getting quite a few answers regarding the state of the US financial system over the coming weeks. We’re just on the precipice of earnings season with both money center banks and regional banks reporting earnings over the coming weeks, we should get a lot of information about what is happening with their deposit basis, what is happening with their earnings, and their outlook for the rest of the year. So that's the first thing to highlight.

Secondly, I think it's important to take a step back and as we consider potential contagion from it. To put this in the context of the US policy response, we know what the regulators will do in response to worsening conditions in the financial sector. We have already seen the framework that has been applied in the SVB situation and in the Signature Bank situation; uninsured deposits where guaranteed.

And we already heard commentary from Treasury Secretary Yellen that a blanket deposit guarantee would be considered were pressures to escalate in the US. So, that is very important. We know what the policy response will be and that should prevent a contagion from spiraling out of control. It is fair, however, to ask if we could see a worsening situation at individual banks?

Can we see a meaningful flight of deposits out of individual banks? Yes, that clearly can happen for smaller, weaker institutions. And indeed, over the recent weeks, we saw more than $400 billion of deposits leaving commercial banks in the US. But before we start getting really scared, let's put that in the context of the entire deposit base. All we have experienced so far is about 3% outflow of deposits.

But also remember that that $400 billion of outflow compares to close to 5 trillion of inflows since the COVID crisis. So, it's a drop in the ocean compared to the extra deposits that banks amassed in the last few years. Going forward, rather than worrying too much about the contagion spiraling out of control, what we think investors should focus on is how the challenges of the U.S. financial system will impact profitability of the banks, but not necessarily the credit profile.

It is fair to assume that banks will see a pressure on their net interest margins as they have to be more competitive to retain deposits. It is fair to say banks will accrue extra charges associated with raising more capital to strengthen their balance sheets. And it's also fair to say that we will see increased losses, especially in their commercial real estate portfolios.

That doesn't mean, however, that the impact for credit holders will be the same as for equity holders. Credit investors will benefit from stronger capital ratios. Credit investors will benefit from management teams becoming more conservative in the months and quarters ahead. So, when we are looking at the US banking crisis, in reality, we see that as a crisis of bank profitability, at least compared to what was expected by equity investors before.

But it's not a solvency crisis and we think credit investors should find a lot of comfort in that distinction.

Given what you just explained, with the dislocations that have occurred in the financials and banking sectors, what opportunities are you seeing at this time and how are you trying to take advantage of some of these recent dislocations?

It's true that we have experienced a great level of dispersion of returns within the financial sector. A lot of issuers, particularly US banks, saw spreads of their bonds widen aggressively over the recent weeks.

And that creates very interesting entry points for investors, in our opinion. We like senior banks and especially larger US regional banks. In that case, we have witnessed spreads often more than doubling over the recent three, four weeks for institutions where those bonds are single-A rated.

We expect them to weather the current storms in good shape and the current spreads are actually more equivalent to a high yield rate at security than of a strong single-A rated bank. So that's clearly an area where we put a lot of focus identifying those regional banks with the stronger balance sheets, less exposure to commercial real estate. That trade at these attractive levels.

Looking at US money center banks, we also find interesting opportunities there, particularly when it comes to subordinated debt. Since the senior subordinated spread ratios have expanded a lot over the recent weeks, particularly in the case of callable bonds, that also creates an interesting entry point in our opinion, for investors that wants to take advantage of major underperformance of US financials compared to nonfinancial corporates.

I'm interested to get your thoughts. How do you navigate market volatility that is driven more from a lack of confidence versus any real fundamental issues?

That's a very interesting question because that is something we often face in our response to market events. You have situations where market activity does not have much basis in fundamental developments of an issuer, and yet prices move up and down. Our job is to make money for our clients, not just being right. So, it's an important skill to navigate markets when sometimes events not connected to fundamentals could be the overwhelming drivers of performance.

So, a couple of thoughts in this respect. First, it's important to understand that within our portfolios we can use liquid derivatives to help protect portfolios at times of dislocation. That is important because it means that you can hold on to your high conviction bond holdings even when the market is hitting a speedbump due to unforeseen circumstances or things we disagree with.

Having the ability to hold on to your core convictions and use liquid derivatives to protect the portfolios in a simple low-cost manner and is an important tool at our disposal. The other thing to highlight is the fact that over the many years that we have invested as a team, it is exactly the times when market volatility spikes, but we do not find a fundamental basis for such price action, that you can get exposure to the best opportunities during that cycle.

From our perspective, then the challenge is how do we manage overall portfolio risk to make sure that we act consistent with the guidelines that we have agreed with our clients while at the same time having the flexibility to take advantage of those dislocations and when other investors are running for the door, giving us an opportunity to take the opposite side of that trade and generate alpha as a result.

A very good example of that was the spring of 2020, when financial markets had almost stopped working as we were dealing with panic associated with the COVID crisis at that time. You've seen issuers losing access to the Commercial Paper markets, bonds exploding in terms of this credit spreads where strong investment grade rates of issuers were overnight trading at spreads that only a week beforehand was seen in the high yield markets.

A very good example of that was the spring of 2020, when financial markets had almost stopped working as we were dealing with panic associated with the COVID crisis at that time. You've seen issuers losing access to the Commercial Paper markets, bonds exploding in terms of this credit spreads where strong investment grade rates of issuers were overnight trading at spreads that only a week beforehand was seen in the high yield markets.

Thank you for that. We're going to switch gears here and talk about some of the main macro themes out there for the last several years and this year, especially involving stickier inflation. The Fed's ongoing attempt to control inflation, uncertainty with how long rates will stay at these levels and now how the banking stresses fit into this whole equation.

So, what are the likely scenarios of how this all plays out? What's our current view and what would cause this view to change?

Well, we approach this topic with a degree of humility, because it's fair to say that over the recent years, market participants, including policymakers, have been shamed by their lack of ability to forecast the exact path of inflation and economic data. But it is fair to say that earlier this year, markets faced the problem of what to do with inflation that was not moderating at the pace that was necessary to satisfy expectations of Federal Reserve.

We made good progress in combating inflation towards the back end of last year, in the very beginning of this year, but after that it almost felt like we hit a wall. And further moderation in inflation was very small and disappointing. This has raised concerns within the market that the Fed will have to go much more aggressively and hike rates to such a point where we see renewed progress in the fight against inflation.

Only a couple of weeks ago, before the financial crisis, investors were discussing peak Fed rates at around 6%, something that has already been forgotten. Well, the financial crisis that occurred in the recent weeks helped to act in such a way that helps inflation come down in the quarters to come. How are they connected? Well, the main channel through which we will see inflation moderating is the impact of reduced bank lending and how that contributes to slowing down the economy.

This, in turn should help moderate inflation. So coupled with Fed rate hikes and we do expect one more at the next meeting, we will have another contributor to the declining inflation coming from the lending channel and from the banking community. We expect that as banks reduce their lending activity and further tighten lending standards in the US, we should see over the coming months an impact on the real economy and by extension, lower inflation.

That is very important because if we see a renewed moderation of US inflation, particularly when it comes to core US inflation, the measure that Fed focuses on that can open the door to rate cuts later this year or at the very beginning of next year. And fixed income investors should see that as of paramount importance because there is a world of difference between an economic slowdown, potentially a recession at a time when the Federal Reserve cannot help you, when Federal Reserve cannot cut rates because of stubbornly high inflation and an alternative outcome when this slowdown is happening at a time when inflation is moderating.

And that allows federal Reserve officials to cut rates, provide accommodation and help the economy to recover over the quarters to follow. We strongly believe that one of the key factors that prevented many investors from reengaging with US fixed income over the recent weeks has been lack of clarity about the path of inflation and the fear that the Fed will have to kill the cycle to address the inflationary problem.

If that is no longer the case, if we start seeing inflation moderating again and that is our expectation, then perspectives on fixed income will change and investors will be much more willing to take advantage of the currently attractive entry points and see flows come into the asset class supporting valuations across US fixed income.

Andrzej, you mentioned recession, and with any economic downturn there would likely be an inconsistent impact across different sectors, industries, insurers. So how are you looking at the current situation and are there any areas you're avoiding at the moment and any areas that you're taking advantage of?

It is true that in a normal recession, those sectors that are much more growth sensitive in nature will see greater volatility. For those issuers, their bonds, all the securities within the fixed income universe and equity. So, this is the reason why we tend to avoid deeply cyclical issues at this juncture. We do not believe that the repricing in those sectors has been sufficient enough to account for the risk of an economic slowdown.

The key reason why cyclical credit tends to trade at expensive levels has been the lack of issuance from companies both in high grade and high yields within those areas of the economy. But those technical factors should not be confused with fundamental strength of those issuers leading into a slowdown. So that is the key reason why we much prefer areas of the markets where a major spread dislocation has already occurred.

Like US financials that we described earlier, or in areas that have much less growth sensitivity like US technology space, were in a recession. Yes, profitability could decline five, 10%, but we are not talking about the clients much greater than that. So, this is the reason why across our portfolios we do prefer defensive issuers, those with less growth sensitivity and US financials, whereas we tend to underweight deeply cyclical credit.

So, investors are coming off a lackluster year for total returns in their bond portfolios. Now, potential credit concerns may be on the verge of recession. How should investors be thinking about their return expectations for the remainder of this year? And given that bonds are offering more attractive yields again, what are the best ways we can take advantage of opportunities today?

It's true that return expectations look much better this year than was the case in 2022, with double digit negative returns in fixed income. Many investors were deeply hurt by the underperformance of the asset class. Well, last year’s pain allows for a much better outcome in 2023. The reason being, as you rightly mention, much higher yields on offer that investors can get exposure to.

In our asset class, those yields often matter because the carry associated with those yields, the return that you will see in your fixed income portfolio. I think if other things were not to change pace for many a danger ahead, even in a world where you see why the credit spreads where government bond yields might have to rise from current levels if inflation were to prove stubbornly high, even in that world, you should still expect flattish returns because the yield of the asset class compensates for the negative impact of those adverse factors.

Conversely, if we see a world where spreads tighten over the next 12 months, something that we see a high likelihood of, and at the same time, core government bond yields rally from current levels as focus shifts from Fed hiking cycle to Fed cutting rates, that can put returns for US fixed income investors in double digit range over the next 12 months.

So, compared to double digit losses in 2022, having an outcome when your downside scenario is flattish returns, but your upside scenario involves double digit positive returns, is a much better risk reward scenario.

Yes, absolutely. That's a great point and something that investors will like to hear after a difficult 2022, to say the least. So, I think that sums it up very nicely. Well, great. Thank you, Andrzej. Thank you for your time and sharing your valuable insights with us. It sounds like it will certainly be another eventful year ahead. So really timely to get your thoughts and how you are approaching and navigating markets going forward.

Thank you to our listeners for tuning in to this episode of The Navigator. Please make sure to look out for our next episode where we will be discussing the US debt ceiling with Brandon Swensen, Senior Portfolio manager on the Global US fixed Income team. Thank you.