AT1s: when refinancing a 5% bond at 7.25% makes sense
In the immediate aftermath of the UK’s vote to remove itself from the European Union in 2016, a premium on UK domiciled or sterling denominated assets emerged. This so-called ‘Brexit premium’ was to become a feature for many years, as markets priced in a cushion that investors apparently required to hold UK risk over its developed market equivalents.
In fixed income, that simply meant wider credit spreads on UK or sterling denominated bonds. It was hoped that once the UK had successfully negotiated its exit and agreed a new trading relationship with the EU that this premium would gradually be eroded, delivering some capital gains for investors that took the risk. Sadly this erosion never quite happened. The discussions dragged on and even when the final fudged deal was squeezed through, a modest Brexit premium remained to compensate investors for the uncertainty surrounding how the UK would cope with this new relationship with its biggest trading partner. Investors holding higher yield bonds that went on to mature still happily collected their premium for taking on the extra risk, but many will have been hoping for more.
UK assets’ post-Brexit experience has been disappointing for investors, as the premium first stubbornly remained and then began to grow again as the political uncertainty of the Boris Johnson era eroded confidence in what has historically been one of the most stable political set-ups in the developed world.
Those hoping a Liz Truss government would provide a clean break from the Johnson era had those hopes dashed within days as market confidence was eroded further by a string of inexperienced and rushed decisions. None of these are worth revisiting for the purposes of this short note, but the result is the risk premium for holding UK assets has not been this large since the UK was dumped out of the European exchange rate mechanism (ERM) thanks to the sterling crisis of 1992.
In our view, the size of this risk premium is fully justified. Brexit left a damaging dent in the UK’s trading relationship with Europe, and the lower availability of cheaper labour from Europe (among other things) has contributed to the UK having the worst inflation profile among major developed markets.
The Bank of England has struggled with its messaging since the departure of Mark Carney, and it is currently engaged in a standoff with the markets over its withdrawal of support for pension schemes faced with a liquidity crunch. Making matters worse (though probably only temporarily) the new finance minister Kwasi Kwarteng and Carney’s replacement as BoE governor, Andrew Bailey, seem to have begun a blame game which neither of them is likely to win.
Should the Brexit premium be renamed the incompetency premium? We would hope not, but an additional credit risk for sterling and UK assets is fully deserved and we know many of our readers will, like us, be finding the whole debacle quite frustrating. The bears are certainly winning at the moment.
However, we should look past the mud-slinging and alarmist headlines and remind ourselves of a few realities. The UK is a strong G7 economy with stable political roots, and it is home to many, many fantastic companies that are run by some of the world’s leading talents. The UK has a banking system that most countries would aspire to, and it is from here that I shall draw one example of how over-excited I believe the markets have become.
The UK is rated AA-, while Turkey is rated B. Turkey was rated BBB- when President Erdogan came to power in 2014, and since then he has enacted policies that would strain any banking system. So as a relative value exercise, let’s look at UK bank Barclays against Turkish bank Yapi Kredi. In Additional Tier 1 (AT1) bonds Barclays is rated BBB- by Fitch, while Yapi Kredi is rated Caa3 by Moodys. Today, the yield on Barclays’ 8.875% coupon AT1 is higher than the yield on Yapi Kredi’s 13.875% coupon AT1. I know which bond I would rather own.
Looking more broadly, if we take an index snapshot and look purely at spreads, UK high yield has a spread-to-worst of 717bp over risk-free, while European high yield is at 630bp and US high yield is at just 534bp.
Again, we think the UK’s risk premium is justified, but how large does it need to be? Given the sources of this premium, it may well exist for some time yet, so investors can either decide to shun the sector completely or they can go fishing for the many great companies that are either UK based or issue in sterling and are trading at excessively wide levels. In the world of fixed income investors do not need the premium to erode or disappear to make excess returns, they just need the companies to pay their coupons on time and when the bonds mature they will have enjoyed excess returns. Looking at the comparison between Turkish and UK banks, maybe the sentiment shift has gone too far and a dose of sobriety is required.
That said, next week is likely to be full of headlines when the BoE’s support programme expires and market participants decide how to play the Gilt market.