UK corporate debt: keep calm and carry on
UK interest rates are likely to remain at very low levels for some time to come, says Chris Higham.
Given the turmoil in global markets since the start of this year, and the absence of any real inflationary pressure, the prospect of a rate rise in the UK in 2016 is becoming even more distant. But leaving aside predictions of when rates will increase, investors should be aware that the next hiking cycle is likely to take on a different form to previous cycles, which has specific implications for credit.
Most investors are accustomed to a world governed by the orthodoxies of the interest rate and economic cycles as depicted in the chart below.
Conventional wisdom has it that an interest rate-hiking cycle is bad news for bonds, but the next cycle may well be different. We are mindful that the best potential for investment returns within fixed interest has passed. However, there are good reasons why rates have remained low for so long and why they are likely to rise gradually, and peak at much lower levels than has been the case in the past.
The hunt for yield will persist for some considerable time and the volatility surrounding movements in interest rates could provide investors with significant opportunities
Consider the evidence:
– Despite the focus on increasing interest rates in the US and the UK, globally around 30 countries reduced interest rates in 2015.
– A number of central banks in developed economies have increased interest rates since the GFC, including those in Australia and Sweden. Most have since been forced to reverse course and have since cut interest rates.
– Global growth in 2015 fell to its lowest level since 2010, according to the IMF, which has warned that growth will disappoint in 2016 too.
– Around 28 per cent of euro-zone sovereign bond yields in the Merrill Lynch Euro Government Index are currently in negative territory, with 43 per cent yielding less than 25 basis points.
A number of reasons have been advanced to explain why growth, inflation and interest rates remain subdued around the world. These include:
The debt overhang:
Governments, households and financial sector debt levels remain extremely elevated in both developed and developing economies. The build up of household and financial sector debt was well advanced ahead of the GFC. However, government debt levels have subsequently increased significantly, reflecting the rescue of the financial sector and the large deficits incurred in an effort to stimulate economic recovery since 2008. Public sector debt in the advanced economies is currently at its highest level since the 1940s, and even in the US, where the economic recovery has been strongest, there has been little progress in reducing leverage across the wider economy over the last five years.
Other key drivers of low growth and inflation also include:
ageing populations, inequality, technology, investment, and productivity.
Interest rates are likely to remain low as a consequence of the debt and demographic picture, and the subsequent drag on economic activity via consumption and investment. The policy response is likely to evolve further with policymakers probably relying on macro-prudential policies to pre-empt any potential side effects that may occur because of low interest rates. For example in the UK, the Bank of England’s Financial Policy Committee continues to extend the powers at its disposal with regards to mortgage availability. Controlling the supply of money is as important as controlling its price.
Interest rates are a blunt tool
It is very difficult to set one interest rate that is appropriate for the entire UK housing market. In addition to macro-prudential policies, the governor of the Bank of England may well continue to use forward guidance in order to influence household behaviour and encourage further household deleveraging. Central bank officials in the UK and the US will also emphasise to financial markets that rates will rise gradually and increases will be heavily flagged.
Where does this leave fixed income?
The likelihood that rate increases will be more modest than in previous cycles is supportive of fixed-income markets for a number of reasons. The hunt for yield is likely to remain in place, which should attract investors to credit, where real yields remain attractive. This may surprise those investors who simply look at nominal yields. The chart below, which shows real and nominal yields for sterling non-government BBB-rated bonds, illustrates this point.
UK corporate debt will continue to offer opportunities
Concerns over the quality of government, financial and household balance sheets continue and corporate debt is the bright spot within fixed income given the attractive credit spreads on offer relative to low default rates.
In a worst case, even if interest rates rise by more than the market expects, investors are able to manage their interest-rate exposure in order to reduce the potential for capital loss.
In conclusion, we anticipate that the much-heralded hikes in interest rates, when they do finally occur in the UK, may not have that great an impact on corporate debt. Moreover, corporate bond yields in the UK are attractive enough to offset any rate hikes, which should be well telegraphed and gradual. Finally, the hunt for yield will persist for some considerable time and the volatility surrounding movements in interest rates could provide investors with significant opportunities.
Source: Barclays; Bloomberg, January 2016
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- There are good reasons why interest rates have remained so low for so long and why they are likely to rise gradually, and peak at much lower levels than in the past
- The debt overhang and ageing populations are among the factors that point to continuing subdued economic growth and inflation, and `low-for-longer’ interest rates
- Corporate debt remains the bright spot within fixed income given attractive credit spreads relative to low default rates
- Corporate bond yields in the UK are attractive enough to offset any rate hikes when they eventually arrive