04 November 2019
In recent years, as the UK lurched from one political crisis to another over Brexit, we have had the proverbial ‘blood on the streets’ in terms of investment attitudes towards the UK. And while it’s not all ‘sunlit uplands’ ahead, the backdrop has changed for the better and this should prove beneficial for higher yielding UK companies.
UK high yield bonds have primarily suffered due to the risks associated with the UK crashing out of the EU without a deal. While uncertainty and brinkmanship are still high, and the official Brexit policy has become ‘harder’, the latest extension to the Brexit deadline and the cross-party agreement for a December election has meant that no-deal Brexit fears have largely receded.
The pound has rallied, partially weighing on translation effects from overseas earnings, but the overall impact on UK corporates from the elimination of a no-deal outcome is clearly positive. The UK has become investable again.
Some rebound in confidence, despite rise in defaults
UK companies have struggled to raise capital due to the deteriorating macro environment and the knock-on effect of Brexit on investor confidence. Sterling borrowers have also not been able to benefit from the European Central Bank’s (ECB) bond buying programme which have lifted European credits, increasing the size of the UK discount.
As a result, defaults among companies in the UK, and Europe more broadly, have been on the rise, albeit from a low base. For European companies overall, defaults are projected to rise from 1.4 per cent to 4.1 per cent over the course of the next 12 months, according to Moody’s.
However, UK defaults have primarily been concentrated among a few large names such as Thomas Cook. And while it may be too late for some distressed companies in highly disrupted sectors to benefit from improving sentiment towards the UK, we are already seeing some rebound in investor confidence; some UK companies are returning to the market to raise capital. For instance, in the last week, RBS completed the pricing of $750 million of subordinated notes.
Likely winners: banks, construction, manufacturers and retail
Certain high yield sectors should benefit from an improvement in the UK operating environment. Banks are an obvious beneficiary. If yield curves start to steepen, then banks will benefit as net interest incomes would start to improve. Businesses and individuals have been reluctant to borrow in the last few years so a return in confidence would likely result in growing loan books. Low rates have kept asset quality in check, but a more dynamic economy would clearly benefit through higher margin lending and more robust activity.
A more confident consumer could also lead to a rebound in both house prices and housing activity, which would help both banks and construction companies.
Manufacturers, in particularly automotive companies with complicated supply chains, would feel relief from being spared the prospect of a no-deal outcome which could have dramatically disrupted production. Lastly, retailers who rely on imports both in terms of food and materials would similarly benefit from the lack of both supply chain disruption and the potential for price increases, at least in the short term.
There is still value in UK high yield
Undoubtedly, there will be plenty more twists and turns ahead in the Brexit saga: parliamentary delays, polling headlines, talk of unity governments and all manner of other machinations. We still expect volatility for UK high yield and for these companies to trade at a discount to their European peers, given the ECB’s new bond buying programme. Nevertheless, we believe UK high yield should benefit from improving sentiment and a rebound in macro conditions.
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