Head - Fixed Income Strategy
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We consider the outlook for UK bonds in light of Brexit
Like any good drama, Brexit has had its twists, turns and cliff-hangers. However, every story must eventually end. With the UK parliament recently incorporating additional measures to prevent a “no deal” exit (Letwin Amendment), the probabilities of the UK leaving the European Union without a separation agreement has fallen sharply. Since the Brexit referendum in the summer of 2016, Sterling-denominated UK corporate bonds have traded with a significant premium over both euro and US corporates. The risk of a “no deal” Brexit is not negligible, however, as optimism builds, we would expect UK corporate spread relationships to narrow.
UK investment grade (IG) corporate benchmark spreads are 30-40bp wide to both euro and US dollar denominated markets. To be fair, there is a significant duration difference across benchmarks. UK IG index duration is over eight. However, even when adjusting for the duration difference, Sterling IG still looks cheap. The same can be said for UK high yield (HY) bond markets, where duration differences are less of an issue.
Yields in UK corporates are much higher than what’s found within the Eurozone. UK IG corporate yields are near 2.2%, or 150bp higher than the average Eurozone yield of 0.4%. In UK HY, bond yields are comparable to US HY markets. Looking below the benchmark level, sector distribution should be considered. Indeed, 50% of the UK IG market consists of financials, with half that within the banking sub-sector. An inverted Gilt yield curve can create some drag on net interest margins, and earnings overall. Nevertheless, we believe a deal on Brexit would still be a net positive for the domestic UK financial sector. Though options are much more limited, capital securities (Additional Tier 1 or Contingent Convertibles) issued by UK banks can offer higher yields between 4-6%, depending on the quality of the issuer.
Sector concentrations in UK HY also exist, with cyclicals making up 30% of the benchmark. However, we believe this could provide an even larger boost to benchmark performance, if cyclicals outperform, as we expect. Spreads on UK HY cyclicals average 570bp, or 70bp wide to the overall benchmark.
Unfortunately, for high quality bonds, changes in the risk-free rate can have an impact on returns. If a deal is reached, Gilt yields could trend slightly higher as risk aversion reverses, or as fiscal expansion becomes more likely. Though spreads would tighten to reflect the positive result, total returns may be somewhat limited.
For example, if 10yr Gilt yields trend back towards 1.0% in one month following a Brexit deal, with IG spreads tightening 30bp, this would produce a mere 20bp of total return. However, rising Gilt yields would also likely lift yields in both US Treasuries and German Bunds as well. In our view, cheaper valuations in UK IG could ultimately result in relative tactical outperformance versus IG markets in the US and Europe.
Though liquidity is relatively weaker, UK high yield bond markets may offer a bit more opportunity. In the event Gilt yields rise, wider spreads in HY bonds can provide a greater buffer. If we use the same above scenario for Gilts, and assume spreads tighten 100bp, UK HY benchmark could generate a more robust 3.3% return, in local terms.
For unhedged investors, sterling-denominated markets could produce even better outcomes. As highlighted by our EMEA investment strategy team, the British Pound would be expected to strengthen toward 1.35 versus the US dollar. In the case of HY, tactical returns (including spread compression) for these investors could exceed 8.0%.
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