Higher Rates Making Waves in Financial Sector Credit

Treasury yields challenging range highs have credit market investors shifting their exposure to financial sector credits. Recent tightening in longer-dated bank spreads may be just the beginning if inflation expectations push rates higher. 

Comment

Shifts in expectations for Treasury rates have been the driving force behind the relative performance of financial credits. The chart below shows total return performance for the Bloomberg Barclays finance, industrial and utility indices. Demand for shorter duration financials has risen each time Treasury yields threatened to break higher. Rising Treasury yields in February and May saw financials widen the margin of outperformance over longer-duration utilities. The margin has widened further this month at over 180 bps. 

We’ve seen the dispersion of total return performance among financials begin to widen in the last few months. August saw a wave of conservative positioning among credit investors, with top-rated real estate outperforming among investment grade credit (see chart here). The boom in healthcare equities has spilled over into healthcare services in the credit space.

The chart shows average 2018 total returns by industry group in the Bloomberg Barclays financial index. The x-axis shows the duration in 2-year bins. Mark size reflects the total par outstanding in each industry group and bin. The rebound in REITs and healthcare services left bank paper lagging its peers at longer durations. 

But banks are already beginning to make up some ground. The next chart shows the average 1-month change in spread to benchmark Treasuries, again by 2-year duration bins. Longer-dated bank paper has caught a bid with spreads tightening 6-9 bps in September. In contrast, insurance paper at the long end has lagged. 

The next chart is the same, showing average 1-month changes in spread to Treasuries for just the banking industry group. Super regionals like Wells Fargo and PNC have been the top performers on a spread basis, with diversified (investment) banks trailing. Both charts illustrate the demand for short-duration paper of almost any kind. 

The Fed is likely to deliver on the relatively hawkish stance the markets anticipate. The real question is what will happen with inflation expectations? That will ultimately drive the path of Fed hikes and term premium, and inflation expectations will need to break above 2017 highs to send a clear signal. 

If things continue moving in the direction of sustained higher yields, we may see credit investors continue to take exposure selectively at the long end of the curve and less discriminately at the short end. 

The last metric we’ll be watching is rolling quarterly excess returns. This is the difference between 65-day changes in total return index for each industry group and the Treasury index. On average, investment grade financials have delivered 141 bps over Treasuries in the past quarter, about 20 bps above the average across industry groups. Finance companies (+188 bps) and health insurance (+156 bps) lead but banks have surged since mid-month to +143 bps.