Credit risk in focus amid bank tumult

The ongoing bank tumult on both sides of the Atlantic has reinforced a tightening of financial conditions, making credit risk re-appear across the board. This has prompted us to change our investment views while sticking with a risk-off stance: We stay nimble and underweight most equities, downgrade credit to neutral on tighter credit supply for borrowers and prefer very short-maturity government bonds for income.

The latest development: an agreement that Swiss bank Credit Suisse would be taken over by a larger rival in a deal that forced punishing losses on its shareholders and some bondholders. The deal has reduced the near-term risk of potential contagion. The key now: whether it can halt the deposit flight from Credit Suisse that had added pressure to its longstanding issues. Policymaker measures to stabilize the situation in both the U.S. and Europe have hurt the bank’s shareholders and some bondholders. We think these events should drive up the cost of bank funding, crimping the supply of credit to the economy.

One unusual feature of the Credit Suisse deal was that Additional Tier-1 bonds, or AT1s, were written down to zero even as shareholders received a small payout. AT1s were developed as an asset after the global financial crisis to help buttress bank capital. AT1s typically convert to equity in times of stress and are not expected to suffer larger losses than equity. In this case, the Swiss government backstopped the takeover – and Credit Suisse’s bonds had hard-wired into their terms that they would be written down to zero if the bank benefited from government support. Such terms are rare outside Switzerland, so this would not happen elsewhere, in our view. The European Banking Authority confirmed today that euro area ATIs will not suffer greater losses than shareholders. Yet the write-down of Credit Suisse’s AT1s has caused a re-evaluation of their risks. We see issuance costs increasing as a result.

Markets have been quick to price in central banks cutting rates to stabilize the situation. That’s the old playbook, and we think it no longer applies. The reason: persistent inflation, as confirmed by last week’s U.S. CPI. We see central banks sticking to a “separation principle” – using balance sheets and other tools to ensure financial stability while keeping monetary policy focused on reining in inflation.

The bottom line: We stay underweight developed market (DM) shares. We cut investment grade credit to neutral and turn underweight high yield bonds given tighter financing conditions. We stay overweight short-term government bonds and prefer very short maturities. We upgrade inflation-linked bonds to a bigger overweight. We prefer emerging market (EM) assets and add an overweight to local-currency bonds to our relative preference for EM equities.

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