With the March 2019 deadline for Brexit looming, we discuss the outlook for the sterling investment grade (IG) market over the next six to 12 months. It is worth noting at the outset that the sterling IG market is not just about the U.K. More than 50% of issuers in the ICE Bank of America Merrill Lynch Sterling Non-Gilt Index are domiciled outside of the U.K., making the index more akin to a sterling-denominated global bond market than a U.K. bond market. As such, Brexit is not the only consideration when investing in sterling IG credit.
PIMCO became more cautious on corporate credit at the end of 2017. IG corporate credit spreads are currently trading near their five-year average (see Figure 1). We have long held the view that sterling credit, given the less liquid nature of the market, needs to trade at least 25 basis points (bps) wider to U.K. government bonds (gilts) than equivalent bonds in the dollar IG market trade versus U.S. government bonds (Treasuries). Recent moves in bond spreads have left sterling IG corporate credit trading at 144 bps above U.K. gilts, whereas dollar IG corporate credit trades at 119 bps greater than U.S. Treasuries. Despite the sterling IG market’s international composition, the main event over the next 12 months is Brexit and with spreads in sterling IG 25 to 30 bps cheaper than other credit markets, there is less room for error.
Looking at market technicals (or bond supply and demand), for a second consecutive year sterling IG credit markets have seen inflows, with much of the flow coming from retail clients (see Figure 2). In 2017, we observed a substantial increase in sterling-denominated credit new issuance as U.K. corporations sought to refinance debt and extend the maturity of their debt. Additionally, U.S. companies took advantage of the longer-dated nature of the sterling IG market to increase issuance in sterling credit. This year, issuance has fallen in volume, and we anticipate a 12% decline in issuance over the whole of 2018, in part due to declining issuance from U.S. companies. Thus we see the market technicals as positive for the sterling IG market in 2018.
When we look at corporate fundamentals, the potential challenge of Brexit becomes more acute. In June 2016, when the U.K. population voted to leave the European Union (EU), the market reacted negatively with a sharp decline in sterling versus both the euro and U.S. dollar. Gilts rallied and sterling IG credit sold off sharply. That negative reaction lasted barely a month, as the market’s perception was that the U.K. would find a sufficiently benign outcome for the U.K. economy and the longer-term prospects would not be as badly impaired as initially feared. However, the subsequent lack of clarity over Britain’s future relationship with the EU has hurt both corporate sentiment and consumer confidence, and as a result the U.K. has seen lower economic activity.
In contrast, the weaker pound has helped much of the U.K.’s largest exporters and those companies with international earnings (mining, energy, pharmaceuticals). Foreign direct investment in the U.K. has not declined dramatically since June 2016, and while unemployment is at multi-year lows, real wages remain non-inflationary, contributing to concerns about consumer spending. Overall, the domestic side of the U.K. economy has suffered due to consumers being more cautious, while exporters have seen an increase in demand.
Recall that the sterling IG market is composed of about 50% non-U.K. companies and that global growth has been generally positive since the U.K.’s 2016 referendum, so from a fundamental perspective, IG companies issuing in GBP are in broadly positive shape. However, the return of merger and acquisition (M&A) risk in Europe makes us wary of lower-rated IG corporate credit. An environment of higher M&A activity brings with it the risk of increased leverage and the associated risk of downgrades from IG to high yield (HY). With all of this in mind, we see the fundamentals as neutral for sterling IG credit.
In light of the valuations, technicals and fundamentals as outlined above, what is the best way for investors in sterling IG credit to position themselves? While our base case is for the U.K. to achieve an orderly exit from its current relationship with the EU, we do see sufficient reason to have some risk compensation for the possibility of a disorderly outcome.
Despite more than 50% of the sterling IG market being non-U.K. domiciled, we still believe that the risks associated with Brexit require some form of premium in sterling IG versus other markets. Currently only certain sectors in sterling IG offer such a premium.
Since the financial crisis of 2008–2009, regulatory and policymaker pressure has forced banks to improve their credit quality. Banks today, with higher levels of regulatory required capital, smaller balance sheets and less leverage, still offer spreads that are wider than similarly rated non-financials. U.K. banks have widened relative to their non-U.K. peers, owing largely to the fears associated with a disorderly Brexit. We view this pricing differential as an opportunity to add risk in U.K. bank credit – across the capital structure. The Bank of England stands amongst the most demanding of global banking regulators, and as such U.K. banks have had to build above-average capital reserves and pass stringent stress tests to prove their viability in times of adversity.
Away from banks, we are seeking pockets of opportunity in sectors which currently offer value and should be able to withstand an uncertain economic environment in the event of a disorderly Brexit outcome in March 2019. The major food retailers in the U.K. trade at wider spreads to non-food retailers and other similar-rated consumer cyclicals. Improving footfall, more stable margins and declining input costs have all helped U.K. food retailers stem declines in performance seen in the years following the economic downturn in 2009. While U.K. wages have been slow to recover and have put U.K. households under pressure, recent improvements in wage growth point to the U.K. consumer being in a stronger position today.
With a PIMCO team of more than 60 credit analysts who independently rate the credits we invest in, our views often vary from the major rating agencies. This variance is often at its most useful at the horizon between IG and HY issuers. Over time we have been able to identify rising stars (sub-IG credits displaying improving credentials that potentially point to an IG future) and take advantage of the pricing mismatch. This is also true of fallen angels: credits that have a likelihood of falling from IG to HY at the rating agencies but, in our view, are already showing that their credit decline is likely a temporary state. Currently we see a variety of opportunities in the sterling credit markets that offer high-discretion IG portfolios (i.e., those with the ability to hold sub-IG securities) a chance to take advantage of pricing mismatches. We view this positioning as an alternative source of carry and performance to more conventional sterling IG credits, where we see current spreads as only fair relative to historical averages.
Overall we see the sterling IG market as trading at spreads that are not offering attractive relative value to other large markets, such as the U.S. dollar or euro markets. While our base case remains for an orderly Brexit, we are focusing on sectors which offer compensation for the risks associated with the future path of the U.K. economy. Whether there is an orderly or disorderly Brexit, it’s worth remembering the global nature of the sterling market with global companies issuing in GBP, and that others, such as U.K. banks, are better capitalized and regulated than before. As such, a dramatic widening in sterling IG credit spreads would provide an opportunity to add risk.
For our medium-term economic outlook for the U.K., and the implications for investors, please see “U.K. Outlook: It’s Not Just Brexit.”