Brexit seems to be approaching a major milestone. Though it is important to keep in mind that what might be agreed on this week is a transitional deal between the EU and the UK in order to allow time to negotiate a long term agreement afterwards, this would nevertheless be a very important step forward if it can pass through parliament.
We have long argued that for real money fixed income managers whose mandate is to produce income without currency risk, the Brexit premium embedded in spreads was certainly worth close inspection. In our opinion, the consequences of a hard exit would undoubtedly be negative in the short term as markets do not like uncertainty, but that Brexit would most likely end up being an earnings issue rather than a solvency issue for most corporates. One of the main reasons for this has to do with the strength of the UK’s banking sector, which has capital levels close to three times higher than pre-crisis, allowing the system to absorb a negative shock and continue lending, which in turn should keep default rates under control. Therefore focusing on financials and corporates that did not run direct Brexit exposure through trade with the EU seemed like a reasonable way of safely harvesting the Brexit premium.
Market participants might have become used to this Brexit premium in spreads, but in our minds if reasonable progress in negotiations was to happen then the Brexit premium should be eroded – the Brexit premium gets monetised by means of a capital gain as spreads normalise. This process has started in earnest in the last few days as sterling assets have outperformed and our screens have been flooded with bids, while offers have been very hard to find. A lot could go wrong for the negotiated Brexit process still but markets seem to think this time is actually different. Delays in parliament do not seem to change the trend higher in sterling which is the main barometer of market expectations regarding Brexit, and spreads continue to rally. So is there any Brexit premium left at this juncture? We certainly believe there is.
High yield index spreads in sterling, dollars and euros demonstrate this clearly, in our view. At the beginning of 2016, before the referendum was announced, £ HY spreads were about 150bp tighter than $ HY spreads and close to 40bp tighter than € HY spreads. At the Brexit premium peak, £ HY was trading 150bp wider than $ HY (Q1 2019) and 175bp wider than € HY (August 2019) at the index level. At the moment, £ HY is still trading 85bp wider than $ HY and 131bp wider than € HY. We acknowledge that $ HY was trading at a discount in Q1 2016 due to energy sector issues, and that these indices are different and their composition changes through time as new bonds are included and bonds mature or get called (or default). But for most of the period the average rating of £ HY index has been BB-, the same as the € HY index, while $ HY has been B+ and these haven’t changed that much. In our eyes this tells us there is still substantial Brexit premium to be had at a time when the risk of a no-deal Brexit seems to have eased.
In financials, just one place where we think a Brexit premium is still observable is in Pension Insurance Corporation’s RT1 bond. It is trading at 107.25 at the moment, and anyone who bought the paper at launch could be excused for entertaining the idea of taking some profits. However, the yield of this bond to its 2029 call is still 6.36% and its rating is BBB-. We think attitudes towards sterling assets such as these might change from “no thanks, it’s UK risk” to “it still looks attractive even after the early rally”. This is just one of many examples of both investment grade and high yield securities that offer a rare glimpse of genuine value in the QE-impacted world of fixed income.
In conclusion, we continue to believe the strength of the UK banking sector should keep default rates low even in an adverse scenario, and that this is an earnings issue rather than a solvency issue for most companies. But if we see a deal making its way through parliament, we may see the Brexit premium monetised earlier than we thought via capital gains rather than future income.