TwentyFour Asset Management
Brexit deliberations are currently at a standstill in the UK parliament, as are negotiations with EU representatives. The next steps in the exit process are clouded in uncertainty, with numerous options on the table. In this environment, it’s no surprise that investors are still demanding a spread premium for sterling denominated credit, over and above comparable euro denominated issues.
If we compare the asset swap spreads available on the sterling and euro high yield indices, the premium currently stands at 125 basis points, slightly wider than the average available over the last three years. And when you consider the spread on the euro index is just 360bp, it is certainly worth looking for relative value in the sterling market, provided that it can be extracted safely.
However, while it’s great to benefit from the additional spread for holding sterling bonds, ultimately investors need to book this gain, either through the bond maturing, being called, or by its spread narrowing back towards zero. Admittedly, the latter option isn’t looking too likely in the short term, though investors have certainly been rewarded by issuers redeeming bonds at par in recent times.
So far this year we have seen several of our favourite bonds either being called or tendered for, including those from Nationwide, Coventry, Barclays, Swiss Re and most recently Virgin Money. In total, close to £7bn of subordinated financial debt is leaving the market, some of which is not being returned via new issues, providing technical support for existing bonds but also rewarding investors seeking to cash in on the Brexit premium.
Interestingly, and perhaps surprisingly, despite investor caution, the sterling high yield index has outperformed the euro index since the start of July 2016, just after the UK's referendum on EU membership. Sceptical investors would argue that the real pain will be felt after a disorderly exit and that the risks outweigh the upside, and we would certainly agree that buyers need to tread carefully and avoid issuers that cannot protect themselves from the impact of a hard Brexit.
However, there are a number of issuers in the sterling market that are either not exposed to the final outcome of the Brexit debacle, or are protected thanks to their diversified businesses. For investors that are looking to safely capture additional spread, and are nervous about Brexit, holding short maturity sterling debt should continue to be well rewarded, and should also be a good diversifier in this low yield environment.