Comprehending The Brexit Premium
Since the UK’s decision to exit the European Union in June 2016, we have seen sterling denominated assets trade with what we have referred to as a Brexit premium. The value of that premium is something we have monitored continuously and have sought to capture as much as possible without materially adding to risk profiles.
In fixed income we see this Brexit premium in the additional spread GBP bonds have been offering over the risk-free rate on a currency hedged basis, versus equivalent bonds in other currencies. The reason for the update today is because Brexit as an event at least is now behind us, though both parties are now having to deal with the consequences.
Thus it is worth reviewing how the premium on sterling assets is changing, and we can do this by looking at the high yield bond indices in GBP, USD and EUR, using a spread-to-worst over the relevant government bond curve to remove the currency hedging impact.
GBP HY spreads made their cycle tights back in the mid-cycle rally of June 2014, reaching a low of 298bp. At the same time, EUR HY spreads were 300bp and USD HY spreads were 356bp. At this point, as you might expect, all three of these hard currency high yield markets were pretty much trading in tandem, with a slightly wider spread in USD likely due to the slightly lower quality of that particular index.
EUR HY spreads made their cyclical tights at just 235bp, a level we think they will breach as this current cycle progresses. At this point markets were factoring in a Brexit premium following the 2016 referendum and consequently GBP spreads did not participate in the ongoing spread rally; they were in fact wider than in June 2014, registering a spread of 354bp on the day that EUR spreads hit their lows. This was a sign that the Brexit premium was starting to build. Had GBP assets been correlated and followed the EUR trend, they could have dropped to around 233bp.
USD HY spreads reached their cycle low at 326bp, just before the rout that hit markets in Q4 2018. GBP spreads continued to widen though, reaching 454bp on the same day we saw the lows in USD. So as the cycle progressed, it was clear to us that GBP assets were missing the rally because investors were just too worried about the volatility of the currency, as well as the solvency of some UK corporates.
With a last minute post-Brexit trade deal struck in the final days of 2020, we have seen the Brexit premium being eroded in 2021, albeit gradually. Currency-hedged GBP HY spreads are now at 440bp, with EUR spreads at 340bp and USD at 373bp. So a degree of Brexit premium does still exist. Why is that and will it persist?
In our view the rationale for the premium is certainly weakening and, of course, we can no longer call it a ‘Brexit’ premium. We think part of this UK premium must surely be down to habit. A large part of the international bond buying community shunned sterling assets for several years, and perhaps are just not looking at them with the same intent as they did before the referendum. However, as demonstrated by the gradual increase in the value of the UK currency itself, it appears investors are beginning to return. As far as bond flows are concerned we have observed highly oversubscribed order books for new GBP issues this year as well as broader roadshow participation especially from overseas investors, indicating that they may be returning to the much unloved and undervalued GBP bond markets.
However, it does feel like the UK needs some form of positive catalyst to expediate the removal of the old Brexit premium. Having suffered dreadful economic performance in 2020, the rollout of COVID-19 vaccines in the UK is one thing that the UK government can take cheer from, despite the terrible impact of this current third wave. Could it be that the UK gets its workforce back to the coalface quicker than in other economies, and that this will be the catalyst to accelerate the removal of the premium we see in GBP HY bond markets?
Possibly, but when looking at relative value the UK does still stick out to us as one of the best opportunities, and the rationale for this premium is fading, which is why we would expect to see GBP HY at the top of the global high yield performance tables by year-end.