Which foot will the Italians’ political boot end up on?
Ever since the result of the Brexit referendum we have seen a premium on £ credit spreads, and we have thought it worthwhile trying to exploit this premium – in a measured way. We recognise that the size of the premium may change, but broadly speaking it has been reasonably consistent at around 100 basis points for a typical 5 year BB rated credit; the table below shows where it is today for the the 3 main high yield indices. We have adjusted for currencies by only looking at spread, and then adjusting the maturity to a consistent 5 year maturity and ratings to BB3 to make a level playing field in the right hand column, in order for us to assess the magnitude of the Brexit premium. Of course looking at aggregated indices data masks differences and potential relative value trades in ratings buckets across geographies but it gives a good picture of where we stand overall.
|Index||Yield to Worst||Swapped Spread||Rating||Maturity||Adjusted 5 Yr BB3 Spread|
|£ High Yield||4.75%||337bp||BB3||4.6 Yrs||364bp|
|€ High Yield||2.73%||239bp||BB3||4.95 Yrs||241bp|
|$ High Yield||6.13%||311bp||B1||5.73 Yrs||228bp|
Source: ICE Indices, TwentyFour Asset Management LLP
As I mentioned, to us this premium feels like it is worth exploiting but we don’t think that it will go away until such time that an economically satisfactory Brexit has been negotiated. This could still take a while. We also don’t think that it will get much larger while negotiations are ongoing. Our view is that, as has often been the case, there will be some sort of “fudge” eventually that enables both sides to move on at least partially happy. However even an unsatisfactory Brexit from the UK’s standpoint does not necessarily mean that all £ denominated corporate bonds move wider for a sustained period of time, as many of the companies are not UK businesses, many have strong international (non-European) earnings and some have pure domestic earnings that may be affected by a UK slowdown but not by Brexit itself. We do think though that idiosyncratic disparities will become much more apparent as analysts are finally able to calculate what Brexit means for each company.
In short, for the vast majority of £ borrowers we see Brexit as a potential earnings issue, but not a solvency one, particularly as most shorter dated bonds will mature before the longer term potential negatives of a weaker trading relationship with Europe makes a more meaningful difference. A key input in this conclusion is the strength of the UK’s banking sector. Healthy capital levels and a strict regulator makes us comfortable that access to credit for people and corporates will most likely remain fluent in case of trouble, as was the case in the aftermath of the Brexit vote.
Having said that though, while we are fishing for an attractive Brexit premium, we must be very careful that we don’t catch the hugely unattractive Corbyn premium which could be far more substantial . Naturally we would be forewarned about this as we would have to go through another general election before it becomes a reality. This is a topic that has taken up a lot of debating time amongst the team, and one that we think would be a huge red light for UK risk assets.
Aside from the UK Brexit premium, the table above also shows the richness of the US high yield sector on a spread basis. Yields of course are substantially higher but these erode once placed on a level playing field. Fundamentally this does make sense, as the economic cycle is the most advanced and spreads have narrowed as rates have gone up. But for $ investors, on a risk adjusted basis they would be better paid to consider £ or Euro assets hedged to $ at this juncture.