Fixed income
04 Apr 2019

Whichever Brexit: sterling corporate bonds stay solid

With the UK poised between different Brexit outcomes, sterling corporate bonds arguably provide both a call option, and a put option against Brexit uncertainty.

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Disagreements over Brexit have thrown the UK into uncertainty. Some investors have responded by avoiding UK assets altogether, for the moment. Yet high quality sterling corporate bonds offer an attractive hedge against Brexit uncertainty, offering both upside potential and the chance of downside protection, in my view.

If a deal on Brexit finally passes parliament, the clouds of uncertainty should disperse, and credit spreads on UK companies will tighten. If on the other hand a no-deal exit from the EU – feared to be the worst outcome and a shock the UK economy – were to occur, then the Bank of England would be likely, in my judgment, to step in and support sterling corporate bonds. The Bank of England’s potential support may be seen as similar to a put option: a hedge against corporate bonds falling. Yet it is a put option that comes free, courtesy of Mark Carney, governor of the Bank of England.

On 15 February 2019, in written evidence to the Treasury Committee, Carney indicated that in the event of a no-deal scenario he would expect monetary policy to be supportive. ‘Given the exceptional circumstance associated with Brexit,’ he wrote, ‘I would expect the [Monetary Policy] Committee to provide whatever monetary support it can consistent with the price stability remit given to the Committee by Parliament.’

And Carney has done it before. Six weeks after the UK’s referendum on membership of the EU, which delivered a ‘Leave’ verdict on 23 June 2016, the Bank of England swiftly moved to support bonds. On 4 August 2016, it announced a corporate bond purchase scheme (CBPS). Its purpose was to impart monetary stimulus by lowering the yields on corporate bonds, and so reduce the cost of borrowing for companies. The £10 billion support programme included bonds in well-known UK companies such as AstraZeneca, British Telecom, Imperial Brands and National Grid, as well as sterling bonds of international issuers such as Apple, BMW, and General Electric. The iBoxx GBP Non-Gilts Index gained about 9% in the two months after the referendum (see chart).

 

Source: Bloomberg, as at 21/03/2019.

If Carney were to repeat the measure in 2019, what kind of bonds would the Bank of England buy? The criterion used in 2016 was that they should be bonds issued by companies making a material contribution to economic activity in the UK.  I would expect, should the Bank of England repeat the programme, for the criterion to be very similar. They would buy sterling bonds in high quality, large companies. This is why I believe the best way to construct a portfolio is with this insurance policy in mind.

In the alternative scenario, where a Brexit deal is ratified by parliament (whether the treaty that Theresa May negotiated with the EU or a successor to it) many UK-based companies would breathe a sigh of relief. They would no longer face the additional burden of accommodating a disorderly exit from Europe, the UK’s biggest customer and supplier, and this would lead to an increase in the companies’ perceived creditworthiness, and to a tightening of credit spreads, in my view.

In general, sterling corporate bonds provide more yield than gilts, but less volatility than equities.  With so much uncertainty around at the moment, they provide a happy medium, and should in my view form a key part of a sensible allocation to the UK given the potential upside of a deal and downside protection against a no-deal Brexit.

 

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