Low interest rates feel like a lifetime ago, but it was only in June 2022 that the Bank of England increased the base rate to 1.25%, the first time it moved above 0.75% since March 2009. This came at a time when the BoE was forced to do whatever it could to keep the UK economy afloat. Clearly the BoE wasn’t alone in this, and I won’t dwell on the history.
However, following the war in Ukraine, the UK mini-budget, and modern age record inflation levels, the UK base rate now stands at 5.25%. As a floating rate investor, it has been an interesting ride, and we are still enjoying the high income we get paid on our bonds. We’ve almost started getting used to being paid 7% to 8% coupons (in £) on investment grade (IG) rated European ABS, but this clearly isn’t “normal”. But what is?
As inflation has peaked and the BoE has done enough to slow the economy down, the question is when the BoE will start cutting rates and how fast. That is a very difficult question to answer, and the BoE will look at the numbers and closely track the impact it will have. At the start of 2024, the rates market seemed to be getting ahead of itself, six to seven rate cuts were already priced in for 2024 in the UK, but this has since been toned down to ~4 cuts (bringing the implied base rate to 4.1% by December). The first 25bp cut is fully priced in for June, compared to May and April for the Fed and the ECB, respectively. This is a result of still elevated (core) inflation and the fact that businesses and consumers seemed to have coped better with high interest rates than expected.
That the central banks will start cutting rates this year seems inevitable, whether the UK gets inflation back to target quickly enough remains to be seen, but the direction of travel is clear. So, I don’t find it strange that the question “what’s next for floating rate bonds?” comes up in investor meetings.
If we consider income on a floating rate bond, European ABS is by far the largest deep and liquid floating rate market in Europe, and so let’s go back to basics and see how coupons change as rates get cut (or hiked for that matter). Sterling denominated bonds will pay SONIA plus a fixed margin and SONIA is a daily compounded rate, meaning that coupons don’t change until the BoE has either cut or hiked rates. The below graph shows how coupons will be reduced, assuming that the current expectations of the rates market are correct. It is important to note that floating rate bonds don’t have duration and valuations don’t change if rates move up or down, the only thing that changes is income. That also means that for the typical IG ABS bond the current 7.4% coupon (SONIA + 2.5%) can reduce to 6.6% by year-end.
Source: Bloomberg, BAML Indices, TwentyFour - 31/1/2024
Traditional fixed income theories will say that if you expect rates to come down then you buy duration, but the total return of this trade will be highly dependent on what is already priced in the curves. Currently, there are a number of rate cuts already priced in and, in that scenario, floating rate risk free income should be similar. If the BoE keeps rates higher for longer then floating income is more attractive and if they cut a lot more aggressively then clearly you should have bought fixed-rate bonds (ignoring the fact that if the BoE is forced to make significant cuts, something has likely gone wrong in the economy and spreads will have gapped out).
How many and the speed of cuts by the BoE still remain to be seen and I don’t think that “normal” inflation is a given yet either. For that reason, we continue to believe in the value of ABS as a floating rate investment and, with possibly elevated volatility in the next 12 months due to economic uncertainties, current income is very valuable still. Assuming that the above rate expectations are correct, a single A two-year £ floating rate RMBS bond (priced at par), with a coupon of SONIA + 2.5% will have a 2024 income of 7.3% and a total internal rate of return (IRR) of 6.5%. While fixed income products in general offer good value currently we particularly like short-dated credit and with ABS offering around 1.2% yield pick-up versus £ corporate bonds, holding-period IRRs and especially the current income still make European ABS look very compelling.