09:00 1 July, 2016
Fixed income: One week on from the Brexit vote
After the high degree of volatility immediately following the UK’s vote to ‘Leave’ the European Union (EU), fixed income markets have stabilised to a large extent in the past week.
The ‘flight to quality’ among investors towards assets seen as carrying low investment risk, combined with the prospect of a cut in base UK interest rates by the Bank of England, drove up demand for mainstream government bonds. Higher demand has pushed the yield on bonds – annual investment returns as a percentage of the price paid – lower.
Although the UK government was stripped of its only remaining ‘AAA’ credit rating on 27 June, reflecting a downgrade in its perceived ability to repay its debts, the market for UK government bonds (also known as gilts) has continued to rally since the referendum. The yield on 10-year gilts fell below 1% to a record low of 0.8%.
One area of the fixed income market that has performed especially well since the referendum result has been inflation-linked gilts. The significant drop in the value of the UK pound relative to other major currencies, including the US dollar and the euro, has led to a rise in inflation expectations, as imported goods and services are likely to become more expensive.
With inflation already expected to edge higher as a result of the recovering global oil prices, the Bank of England now faces a difficult decision whether to increase base interest rates to keep inflation in check, or to keep interest rates low to support economic growth.
10:00, 30 June 2016
Fixed income: the limits of ‘Brexit’ fall-out
Richard Woolnough is manager of the M&G Optimal Income Fund
A week on from the British vote to leave the European Union (EU), the early stages of the UK’s divorce from the EU are under way.
While the UK government remains under the same political roof as its continental counterparts until their formal separation, as in many divorces, it is no longer welcome at the dining table – as the summit excluding the UK on June 29 demonstrates.
Reaching an amicable political settlement on the future EU-UK relationship will be challenging, not least because of the distance between the two parties ahead of negotiations, and it will be further complicated by the multitude of EU members who must reach an accord.
The high degree of political uncertainty has prompted volatility in investment markets since the referendum, but it is important to reflect on which assets will be fundamentally affected, and which will not.
Rebalancing in the UK economy
The epicentre of the political earthquake might be the UK, but the shockwaves will be felt across Europe – perhaps especially in peripheral, weaker economies in southern Europe.
Importantly, having its own currency allows the UK economy to adjust to market events in a way that eurozone economies, which share one currency, cannot necessarily. In response to the referendum result, the British pound fell to a 31-year low relative to the US dollar, the international benchmark currency. A weaker currency improves the UK economy’s relative competitiveness by making its labour, goods and services cheaper to buyers in stronger currencies.
The UK also has control over its own fiscal policy (government spending) and monetary policy (interest rates). Its central bank, the Bank of England, is widely expected to keep its base lending rate very low, and perhaps even cut it, to help offset the threat of an economic recession.
Loose monetary policy, combined with a weaker pound – which will increase the cost of imports to the UK – could lead to inflation rising. Higher inflation in the UK does not necessarily concern us, in the short term at least, but it does make inflation-linked UK government bonds, or gilts, more attractive, in our opinion, than gilts that do not protect investors from rising prices.
Identifying value in corporate bonds
Since the Brexit vote, the price of mainstream government bonds – traditionally seen as among the lowest-risk investments – has risen, reflecting high levels of risk aversion among investors. Higher prices have pushed the yield on bonds – annual investment returns as a percentage of the price paid – lower.
In our view, the risk premiums – in terms of higher prospective returns – that are currently offered on certain corporate bonds, compared to lower-yielding government bonds, make them attractive.
Specifically, we think certain investment-grade US corporate bonds offer investors value, not least because these companies will, by and large, barely be affected by any fallout from Brexit.
European corporate bonds, on the other hand, generally offer lower value relative to their US counterparts at the moment, in our opinion. This is partly because the European Central Bank (ECB) is continuing to buy European corporate bonds in large volumes, with this demand keeping bond prices higher, and yields therefore lower, than they otherwise would likely be.
The ECB’s policy of buying corporate bonds is also affecting European banks, as it has effectively presented European companies with an alternative source of borrowing. While we are cautious about the banking sector, we believe large US banks currently display healthier fundamentals – and offer more attractive valuations, relative to the investment risks. We feel this view is supported by positive ‘stress tests’ by the Federal Reserve announced on 29 June.
Volatile markets might be uncomfortable for investors, but they inevitably present opportunities for active fund managers where asset prices stray from their fundamental value.
The UK’s vote to leave the EU has prompted many political and economic uncertainties, but it has happened and the key for investors is to avoid responding emotionally. In our view, the referendum result will have limited bearing on the investment proposition of many corporate bonds beyond the European region.
13:00PM 28 June 2016
UK rating downgrade - M&G Retail Fixed Interest update
After two days of turmoil, financial markets have stabilised this morning, with sterling and UK equities recovering some of their earlier losses at the open. This morning’s relative calm comes despite the news that the UK has been stripped of its only remaining AAA rating, with Standard & Poor’s cutting the rating to AA. This was followed by Fitch, which downgraded the UK from AA+ to AA. So far, however, the downgrades have had little impact on gilt markets, with the 10-year yields still just below 1% as at midday today.
One area of the fixed income market that has performed especially well since Friday has been index-linked gilts. The significant fall in sterling has led to a rise in inflation expectations due to the likely increase in import prices. For more details on this subject, please refer to a blog released before the Referendum, where Fund Manager Ben Lord discusses the potential impact of ‘Brexit’ on index-linked markets.
||Mon close 17140 / -1.5%
|Tue close 15323 / +0.1%
||Tue close 20172 / -0.3%
*Figures, 12pm 28 June 2016 unless otherwise specified
13:00PM 24 June 2016
12:30PM 24 June 2016
09:30AM 24 June 2016
Bond market reaction to the UK’s “Leave” vote
The UK has voted to “Leave” the European Union (EU) in a landmark referendum.
Financial markets had very much discounted a “Remain” vote, in line with the last opinion polls, and there were some significant moves in bond markets first thing on Friday morning.
The biggest market movements have occurred in the foreign exchange markets, where the UK pound fell relative to the US dollar from nearly $1.50 to below $1.35 – lows not seen since 1985.
The Euro currency performed badly too in early trading as both the economic and political implications of the UK’s “Leave” vote were being digested. The Euro was down by over 3% against the US dollar. Questions now include whether European growth will be hit; whether other EU nations hold their own referendums; and what will become of the EU’s periphery and the banking sector.
Within bond markets, 10-year US government bonds rallied overnight, and the yield – the investment return as a percentage of the price – on 10-year German government bonds had moved sharply back below zero by Friday morning. This means that lenders are effectively paying the German government to hold their money. Friday’s early trading follows Thursday’s sell-off in government bonds in anticipation of a “Remain” vote.
While a possible downgrade in the UK’s investment grade by ratings agencies was flagged ahead of a possible “Leave” vote, there is perceived to be no significant default risk for a country that can print its own currency.
The “losers” in bond markets are those assets deemed to be higher risk. Fundamentally, the sell-off in higher risk assets presents opportunities for long-term investors where the market over-compensates for the risk of defaults – borrowers failing to keep up with their debt repayments.
So what about the UK economy? Well, a large majority of economists expected a “Leave” vote to be negative for UK growth. Investment decisions are now likely to be delayed by businesses, and households may also become more cautious. The threat of economic recession – or the UK economy shrinking – cannot be discounted.
As for UK inflation, the significant fall in the relative value of the pound will be likely to lead to higher import prices. Inflation is now expected to rise above the 2% target, but in the interests of financial stability this is unlikely to provoke the Bank of England to increase its base lending rate – a mechanism used historically to stem rising inflation. The response of the Bank of England will be watched very closely.