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MBS and AT1 bond markets – history never repeats itself, but it often rhymes

March saw the start of one of the biggest banking crises in the U.S. since the 2008 financial crash and, along with the unfolding events at Credit Suisse in Europe, sent shockwaves across global markets. There were eerie reminders of the Global Financial Crisis (GFC) in 2008-09, in the rapid deposit outflows from these banks, even if central banks prove correct, and systemic risks remain low.

  1. Credit spreads have widened following the banking crisis.
  2. Even with the significant rates tightening, broad access to capital is available.
  3. Investor sentiment turned fragile after the wipe out of Credit Suisse’s additional tier (AT1) bonds amid higher uncertainty and perceived risk.

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Has “higher for longer” on Fed rates become “too much tightening, too late”?

Before the banking sector turbulence, the bond markets had priced in a scenario of “higher for longer” on Fed short rates to tame inflation. Recent events, however, have altered the financial and policy backdrop and increased the probability of more turbulent scenarios ahead.

In the residential mortgage-backed securities (RMBS) market, typical bank portfolio MBS securities have already adjusted price and duration to the significant rates tightening through 2022, including the Fed’s recent 25bp rate hike in late March 2023.

Stress testing the Yield Book’s base models shows that RMBS securities are reasonably insulated in a wide range of scenarios.

Yield Book and FTSE Russell commentary on the impact of banking woes on RMBS market

Collateral damage from higher Fed rates could be significant

After the latest 25bp raise, the market’s implied central case is that the Fed raises rates a further 25bp by mid-year to about 5.1 percent, but then cuts rates by about 75bps by the end of 2023; a significant disconnect from the Fed’s latest dot plots, which show rates still at 5.1% at end-2023.

These expectations appear driven by concerns about financial stability and the banking sector, and in such a risk-off scenario, credit spreads could continue to widen and risk appetite diminish, and high-yield credit is likely to underperform investment grade.

At the same time, CMBS investments, which typically have heavy exposure to long-duration fixed-rate securities, are susceptible to duration risk amid such market turbulence.

Analysis using Yield Book agency CMBS prepay models and the Yield Book non-agency CMBS credit model shows that in a rising interest rate and widening spread environment, the price decline for some CMBS bonds could be significant.

Any investor holding a portfolio of this type of bonds can potentially be sitting on huge unrealized losses, barring proper rate hedging, although a flight to safety pushes down Treasury yields as an offset (and hence CMBS required yield), leading to some rebound of asset values.

AT1 bond market properly stress-tested after Credit Suisse woes

Recent events also highlight the risks in the deeply subordinated, and loss-absorbing debt of the banking system.

Credit Suisse’s forced merger with its domestic rival UBS resulted in a complete wipe-out in the value of Additional Tier 1 (AT1) bonds after a historic write-down of 16 billion Swiss francs ($17.2 billion) “bailed-in” the bondholders, despite the fact ordinary equity holders in Credit Suisse received some payment for their shares.

This is a reversal of the normal resolution process for a troubled bank, in which any bondholders, however, subordinated, receive some payment before equity holders.

In response, AT1 bond prices of other banks slumped. AT1 bonds, also known as “contingent convertibles” or CoCo bonds, typically provide a higher yield than ordinary bonds and some allow bondholders to convert into equity, in the event of a bank’s capital ratio falling below a certain threshold.

However, others convert to zero, in the event of this threshold being breached.

Indicative AT1 bond prices of major European banks
Source: Yield Book

Although, after the initial crash in prices, regulators sought to assuage market jitters, this event is likely to continue weighing on the wider AT1 bond market, as investors are reminded increasing a bank’s loss absorbing capacity was, and is, a key driver of AT1 issuance.

As a result, it may be more difficult and expensive for banks to raise loss-absorbing debt capital of this type to meet regulatory requirements.

Macroeconomic, cyclical risks for MBS increase as central banks combat inflation

Since the start of the March mini-banking crisis, central banks globally have sought to calm market sentiment and bolster investor confidence. However, both the U.S. Fed and Bank of England raised rates a further 25bp in March to combat inflation and have been prepared to trade-off recession risk in the pursuit of inflation at target.

An economic slowdown, or recession, can exacerbate the duration, and negative convexity risk, as CMBS loans fail to refinance due to reduced net operating income and end up getting extended. Meanwhile, credit spreads will likely widen, and a sustained period of risk aversion would likely pressure valuations across CMBS securities.

Banks and lenders will tighten lending criteria and lending volume, which would hurt loan origination volume and deal flows for CMBS.

Similarly, in the RMBS market, if the Fed tightens interest rates further or maintains rates “too high for too long”, the housing market is likely to come under further pressure, as mortgage rates rise and refinancings collapse.

Yield Book commentary on what the SVB failure means for CMBS

By Paolo Angeles, Yield Book Product Management, Jake Katz, Yield Book Head of Non-Agency RMBS Research, Luke Lu, Yield Book Head of CMBS/CLO Research, and Robin Marshall, Director, Fixed Income and Multi-Asset Research, FTSE Russell.