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.
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).