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Investors’ number one question

20 July 2017 by Graeme Anderson

When talking to investors recently, the first question we are most frequently asked is a version of – “given the implications of Brexit, what drives your exposure to the sterling bond market?”

This is a fair question, and something we have touched upon in various previous blogs (for example, ‘Why global investors should not be scared of UK exposure, 30 March 2017). As portfolio managers, subject to mandate constraints, we are indifferent as to where we find value on a global basis and so our country exposures are always deliberate, considered positions, and we are happy to be able to explain our thinking.

So here is a short summary of what is driving our attraction to the UK market despite the “Brexit” negotiations.

On Brexit itself, we feel that at this stage it is impossible to predict how negotiations will evolve; they could turn out better or worse for all concerned, both in general or for specific sectors. Anyone claiming to know the outcome at this stage should be viewed with some scepticism. What we can say, however, is that the market is understandably pricing in an uncertainty premium, which we feel with some thought can be taken advantage of for our investors.

Looking at the chart below you can see that, in credit spread terms, the U.K. is the cheapest in the AA to BB buckets.

Source: TwentyFour, underlying data Barclays as at 17th July 2017

In absolute yield terms, on the face of it, the US market is more attractive. However, any non-Dollar based investor will have to account for the cost of hedging dollar currency exposure; this is currently expensive at just over 110 basis points for one year, which significantly diminishes the relative attractiveness of the US market.

Source: TwentyFour, underlying data Barclays as at 17th July 2017

For reasons unrelated to Brexit we currently have a low duration bias in our funds, and see value in the pull to par at the shorter end of the curve. We have explained the rationale and benefits of this approach elsewhere (see ‘Rates Sell Off Continues 6 July 2017, ‘Duration Risk’, 15 May 2017, ‘Duration Risk Part II 18 May 2017 and  ‘Duration Risk Part III 22 May 2017) but a consequence of this strategy (i.e. not just reducing duration with a swap but actually buying shorter dated bonds) is that many of our UK bonds will have matured before the Brexit negotiations are concluded!

Uncertainty is the main negative effect that one can identify currently. To the extent that the negotiations look like they may turn out more negative than positive we feel that this will be expressed through company earnings and not solvency (see, ‘Brexit Premium Still Abundantly Available, 16 May 2017). In particular we feel that the UK banking sector is in good shape, thus providing solid access to credit for companies.

Moreover, exposure to pure “UK PLC” is lower than it may seem from a superficial glance. Many of our sterling denominated bond holdings are actually overseas companies that have issued into the UK bond market. In the main those UK companies that issue in the sterling bond market tend to be large and globally diversified (with the exception of some High Yield issuers), with both production and distribution on an international scale. These companies’ spreads get dragged out with the rest of the market, thus offering additional value relative to the underlying risk.

In addition there are sectors such as Residential Mortgage Backed Securities where bonds are attractive due to their structural robustness and are domestic in nature, which will accordingly not be directly impacted by specific trade outcomes.

So in summary, when you combine the relative value on offer in the UK bond market with the points above, we are confident that our current asset allocation bias viewed in a global context offers investors worthwhile yield pick-up, despite Brexit negotiations.

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