Brexit and the bond markets
As the dust settles on the EU referendum, Chris Higham and James Vokins consider the short-term and more lasting implications of the UK's vote to leave on the bond markets.
It was no ordinary morning. In the early hours of June 24, the UK referendum on EU membership delivered an unexpected result: ‘Brexit’. Panic spread, stock markets tumbled, and the pound plunged 10 per cent, to a 31-year low, against the US dollar.
Gilt yields declined as investors sought safe-haven assets, even after rating agency Standard & Poor’s stripped the UK of its triple-A credit rating on June 27. S&P cited political uncertainty and the likelihood of weaker GDP growth in the wake of the Brexit vote as factors in its decision.
Perhaps surprisingly, yields on sterling-denominated investment-grade credit have also fallen since the referendum. This is partly because many of the better-rated UK issuers derive a large proportion of their revenue from overseas and stand to gain a competitive advantage from the collapse in sterling. The average spread on investment-grade debt, as measured on the Markit iBoxx sterling index, fell to 174 basis points on July 13, its lowest level since December 2015.
Look a little deeper, however, and vulnerabilities are evident in the UK credit market. Borrowing costs for UK financial companies have risen since June 24 amid concerns about how a slowdown in economic growth will hurt British lenders. And high-yield issuers, particularly in the retail sector, are coming under severe pressure as domestic demand softens and import costs rise thanks to the weakened pound.
Against this turbulent backdrop, bond investors are keenly anticipating the Bank of England’s policy response. Might governor Mark Carney introduce a corporate bond-buying programme as the European Central Bank has done?
In this Q&A, Chris Higham, Head of Credit Multi-Strategy Fixed Income, and James Vokins, Credit Portfolio Manager, explore the risks and opportunities emerging in an uncertain post-Brexit landscape.
How has the Brexit vote affected the UK bond markets?
James Vokins: The Brexit vote was unexpected and has completely changed both the monetary and fiscal policy outlook. Before the vote, we were anticipating interest-rate rises in the US and the UK – now the Federal Reserve is likely to defer rate hikes, while the Bank of England will probably execute a full 180-degree turn and cut rates. On the fiscal side, changes to UK government personnel have led to calls for more stimulus. Overall the vote has really crystallised market fears about stagnant economic growth and increasing political risk. Government bond yields have fallen as a result of safe-haven flows.
But we’ve also seen interest in credit as investors search for more yield and take comfort in the prospect of further policy easing in the months ahead. Events such as Brexit tend to create an active managers’ market. For bond investors, it’s often more important to avoid the losers than pick the winners; with such a large amount of downside risk, we work closely with the analysts in our research team to avoid any ‘blow-ups’ that may hurt returns on the portfolio. We’re mindful that low interest rates have created cheap money that is potentially generating bubbles in some parts of the market.
There are still opportunities in UK credit, however. You can get mid single-digit yields in sectors where the earnings outlook is stable, as long as you are willing to live with relatively high levels of leverage. We’re overweight in asset-backed securities, financials and telecoms. The telecoms industry is particularly interesting at the moment, as companies are deleveraging and there is likely to be more consolidation across the sector.
What action do you expect the Bank of England to take over the coming months, and what will be the effect on the UK credit markets?
Chris Higham: The Bank of England already owns more than a quarter of the gilt market, around £375 billion. Yields are already very low, and it’s difficult to see what the BoE would achieve by buying more gilts. Instead, the BoE may extend funding-for-lending schemes, or even start buying corporate bonds, as the European Central Bank has done. There’s a precedent for that: during the crisis, the BoE stepped in as a market maker when liquidity dried up in the UK credit markets. But this policy would be quite different if it was targeted specifically at bringing yields down with the intention of stimulating corporate investment.
Would a credit-easing programme spur corporate investment?
CH: It’s possible UK credit spreads would tighten considerably if the BoE started buying corporate bonds. But there are limits to what monetary policy can achieve. The private sector has already been given the opportunity to finance itself very cheaply and, on the whole, it has not done so. If a BoE corporate bond-buying programme failed to stimulate investment,that would illustrate the problem is not a supply of credit but a lack of aggregate demand.
So how do you increase demand? The next step would be fiscal stimulus. The UK Treasury may follow Japan’s lead and try to boost the economy with spending on big infrastructure projects, such as the Hinkley Point nuclear power station, a third runway at Heathrow and High Speed Rail 2. If these projects are brought forward we’re likely to see more gilt issuance.
How has the depreciation of sterling affected the UK corporate bond market?
CH: The FTSE 100 has massively outperformed the FTSE 250 post-Brexit, which shows the value of overseas earnings and diversification. And those two factors are big strengths of the UK corporate bond market, too, at least at investment grade, where more than half of issuers are large companies with overseas earnings. These companies benefit to an extent from the weaker pound.
The depreciation of sterling has also made UK companies more attractive to overseas buyers. Mergers and acquisitions have picked up since the referendum. We’ve seen the ARM Holdings deal [ARM was bought by Japanese conglomerate Softbank for £24.3 billion] and Poundland has also been bought [by South African group Steinhoff]. AMC Entertainment, a Chinese-owned US cinema chain, bought Odeon and UCI cinemas for £921 million. We’re likely to see more of these deals.
But on the other hand, high-yield bonds have been hit by the depreciation in sterling. Companies in the retail sector have suffered a double whammy from the collapse in sterling: domestic demand is likely to be lower and their costs have risen because they source from overseas.
Has the Brexit vote affected market liquidity?
JV: Liquidity always suffers when the market is in stress. But while Brexit is clearly a very meaningful event, we try to focus on the longer-term story. In that respect, a decline in liquidity can actually provide us with opportunities, because when other investors are keen to sell we may be able to pick up bonds with good long-term fundamentals.
How does UK credit compare to the European corporate bond market in terms of value after the Brexit vote?
JV: The growth outlook for the UK is lower than it was before the referendum, and the economy may fall into recession this year. We’re mindful of the potential impact lower GDP growth may have on credit quality. UK credit is currently much cheaper than European credit – spreads are on average about 50 per cent wider in the UK – which reflects that outlook.
But in many ways, Brexit is as much an issue for Europe as it is for the UK. Look at European banks, for example. Do we want to switch out of UK banks – a sector that is overweight in our portfolio – into European banks, given that Brexit is likely to have a growth impact in Europe, too? Italy, in particular, could be vulnerable. Italy’s banking sector is suffering with non-performing loans and much-needed reforms to the country’s insolvency regime have been slow to take root. Compare that to the UK, where the Bank of England has proactively taken steps to support the banking sector by loosening capital requirements. On a comparative basis, UK banks look relatively healthy despite the vote.
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- Gilt yields have fallen in the wake of the ‘Brexit’ vote as investors seek perceived safe havens
- UK investment-grade corporate bonds have proved resilient. Many of the better-rated issuers derive a large proportion of their revenue from overseas and stand to gain a competitive advantage from the collapse in sterling
- High-yield issuers, especially in the retail sector, are more sensitive to the domestic economy and are coming under pressure as a result
- Bond investors are keenly anticipating the Bank of England’s policy response, with a corporate bond-buying programme among the options being considered