Article / 17 August 2016 at 9:00 GMT

Sterling bond revival demands deft asset allocations

Managing Partner / Spotlight Group
United Kingdom
  • The BoE’s expansion of QE program is lowering yields in the UK bond market
  • UK bond exchange traded funds have enjoyed over £146m of inflows
  • In any model, we need flexibility in the parameters - not just a hunt for yield

By Stephen Pope

The Bank of England’s recent relaxation of UK monetary policy, announcing a reduction in rates, also inspired an increase of asset purchases.

Companies have seized the opportunity to issue new debt and in so doing breathed life into the once flagging Sterling corporate bond market. 

The central question now to be asked is whether or not this burst of activity is a mere flash in the pan, or will the BoE-inspired revival flourish and continue?

And if so, from the widened choice of investment vehicles, will the correct assets be chosen?

Yields and spreads decline

The BoE decision to reduce the UK Base Rate to just 0.25% was widely expected - the surprise came in the form of news that the central bank would acquire up to £10 billion of non-financial corporate debt over an 18 month period starting next month.

The yield curve has certainly retreated as the chart below of the issue, Paragon 6.125% 2022 reveals. The yield to maturity fell from 5.750% to 5.000% on the day of the announcement from the BoE.

GBP bond yield

The chart above reveals a sharp rally in the secondary market and as such a new window of opportunity has opened up the market for new debt sales.

In the four trading days following the bank's announcement, ie Friday August 5 through to Wednesday August 10, 25% of all Sterling investment-grade corporate debt issuance this year was launched according to data provider Dealogic.

New appetite for debt exposure

The BoE’s resumption and expansion of its QE program is having the effect of lowering yields across the UK bond market.

With the new-found appetite for debt, balance in a portfolio becomes paramount. Photo: iStock
Both the Markit iBoxx Sterling Gilts and Sterling Corporates indices have seen their yields decline to new all-time lows with both indices trading 29 and 47 basis points (bps) tighter since before August 4.

The collapse of bond yields has boosted investor demand for UK bond Exchange Traded Funds. About 25 such ETFs have enjoyed over £146m of inflows in the four trading days since August 4.

This followed an already strong inflow trend that was witnessed in the days leading up to the BoE announcement. It takes the asset class’s level of assets under management past the £7 billion for the first time ever.

Corporate bond products have attracted the vast majority of the post rate cut flows with over £134m flowing into the asset class during August placing the month on track to exceed the previous inflow record set over four years ago in July 2012.

The decision to allow corporate bonds to be included into the QE basket has seen the spread demanded by investors to hold Sterling-denominated investment grade corporate bonds fall by 20 bps.

This level of spread compression means that the iBoxx Sterling Corporates has returned over 1.7% more than its Gilt equivalent since August 4. 
UK Generic
Source: Institute of Actuaries

Making an investment evaluation

The spreads are important as they reflect an option premium, ie whilst the yield of interest of the bond is expensed in accounting terms, when it comes to spread we have to consider that the option has both cost and value elements.

Recall that together spreads i.e. a “prestige rating” reflects a lower option value, it does not imply one issuer is better than another.

It is better, when making an investment evaluation, to consider how we can build an investment model. Modelling by investment rating or grade is a good parallel to how portfolios are managed in practice.

That said, one has to accept that the perception of what is a superior “A” rated bond. What is an “A” rated bond is subjective and is usually based on out-of-date information and therefore can be arbitrary.

In contrast, if one takes a structural approach because the spread is in effect a mathematical representation of price and value, one can look to correlations that match up comparisons on a Corporate Bond/Government Bond and Corporate Bond/Equity relationship.

These can be calibrated and the structural model output can be arranged into layers of risk/return and expressed as a transition or stochastic matrix. Each of its entries is a non-negative real number representing a probability of a payout or perhaps a default.

Over time risk either improves or deteriorates and these variations are captured by the transition frequencies between risk classes, e.g. AAA, AA,A, BBB etc.

Within a given period, the transition frequencies when divided by the number of original firms in each risk class generate the transition rate.

Therefore, it is possible to map rating classes with observed credit spreads in the market in the matrix and such a mapping allows the investment manager to assign different credit spreads to the final credit state, and estimate the considered value of a corporate bond relative to its underlying benchmark.

This allows the generation of a distribution of values at a forward time horizon for any asset with a given original rating class.

Under arbitrage-free models, corporate bonds behave like a dynamically rebalanced mixture of gilts and equities. There is an equity risk, but the areas in a model where that risk is priced is the equity model and the corporate bond model.

A strategy to implement a reallocation of assets toward fixed income, ie sell equities and buy corporate bonds is a substitution case in which the attractiveness is highly dependent on asset model parameters, in particular the relative cost of equity risk implicit in the equity and corporate bond models.

The main risk is that asset selection outcome determined by asset model calibration and not (much) by business dynamics.

We have to be prepared to keep flexibility in any portfolio parameters but not be so fixated on the hunt for yield that the investment manager will move further and further out on the credit or liquidity spectrum and so dilute or compromise the integrity of the fund.

-- Edited by Adam Courtenay

Stephen Pope is managing partner at Spotlight Ideas
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