How UK Corporate Bonds Price Brexit Fears

How UK Corporate Bonds Price Brexit Fears

Global credit markets have had a volatile year, with spreads widening dramatically in the first quarter before returning to more normal levels. Over this period, sterling-denominated credit underperformed its euro and dollar peers, and many market observers questioned whether this was driven by Brexit uncertainty. In our view, underperformance during the sell-off was due more to lower liquidity in sterling markets, but as global spreads have moderated more recently, Brexit-related fears are likely more to blame for sterling credit underperformance.

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Looking ahead, we think three sectors of the UK corporate bond universe are most at risk from a vote to leave the European Union – with this risk priced in to varying degrees:

  • Financials: Of all sectors, UK banks are most exposed to Brexit, with the key downside risk being a shock to GDP and decline in house prices. Banks do not face sovereign or redenomination risk, but higher funding costs and weaker loan growth would likely follow Brexit. That said, at current valuations, we think investors are being well compensated for this risk. Balance sheets look healthy, and while spreads would widen, the strongest names should be able to withstand any short-term sell-off.
  • Utilities: In contrast, the utilities sector may be underpricing the risk of Brexit. If a vote to leave revives questions on Scottish independence, uncertainty over the future regulatory and policy framework may lead the ratings agencies to downgrade certain names. Considering these policy risks, together with the high exposure of utility companies to the UK domestic market, we remain wary of the space.
  • Non-food retailers: Finally, the non-food retail sector also looks exposed. Most products are imported and a weaker sterling would drive up input costs. At the same time, non-food and discretionary spending may fall due to general uncertainty and any associated GDP decline.

Does the vulnerability of these sectors mean you should avoid UK corporates entirely? Not at all. We believe UK bank debt currently provides good compensation for risk, and outside of this, there are other sectors and companies – food retailers where investors are rewarded by wider spreads (both investment grade and near investment grade issuers), or certain exporters – for which Brexit could have positive effects. However, it does suggest a differentiated approach, overweighting sectors and issuers where the compensation for risk seems appropriate. And on a portfolio level, it may mean hedging corporate exposures that are most vulnerable to Brexit through selling sterling or buying UK gilts (see How to Play the Brexit Blues for details on this).

DISCLOSURES

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. It is not possible to invest directly in an unmanaged index. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.