When the Bank of England (BoE) embarked on its first Asset Purchase Facility (APF) from March 2009 to February 2010, it did so to boost U.K. money supply, aid corporate liquidity and keep long-term interest rates low by buying U.K. government bonds, high-quality commercial paper and a limited number of corporate bonds. By the close of the programme, the BoE purchased £200 billion worth of assets, mostly government securities. These asset purchases represented 27% of the outstanding nominal gilt market and 22% of the total gilt market, according to the UK Debt Management Office. In addition to its £198.5 billion gilt purchases, the BoE acted to buy investment grade corporate bonds. By the end the programme, the BoE bought a total of £1.5 billion worth of corporate bonds. It set out very clear restrictions on the type of corporate bonds it was prepared to buy: no securities with optionality such as calls, puts or sinking funds; and most importantly no securities issued by financials. It largely limited itself to issuers with business activity in the U.K. We don’t believe the APF was designed to buy up significant chunks of the U.K. credit market nor to support banks’ ability to fund themselves. Nonetheless, by acting as a market maker of last resort for selected non-financial issues, the BoE succeeded in stabilising the sterling credit market without having to commit a huge amount of balance sheet.
When announcing the latest round of quantitative easing (QE), the BoE made no mention of the corporate bond market, choosing to focus again on the gilt market. However, the BoE’s recent decision to expand its balance sheet through a further £75 billion worth of asset purchases over four months is likely to see gilts outperform other government bonds and conspire to exert further flattening of the gilt yield curve. But what does that mean for the sterling credit market?
Overall, we view the latest round of asset purchasing as credit positive for a number of reasons, the main one being its potential effects on portfolio rebalancing where suppressed yields in the “risk-free” market may encourage a flight to riskier assets. The removal of government bond supply combined with the likely suppression of yields may encourage investors to seek out greater yield via investment grade bonds in the credit markets. With sterling credit spreads back at wider-than-average levels (see Figure 1) and gilt yields just off their all-time lows (see Figure 2), sterling-based fixed income investors are likely to seek out alternative sources of yields and continue to be attracted by the wider spread levels in the sterling credit market. Adding to the attraction is the considerable amount of investor cash sitting on the sidelines looking for a home. For example, the recent £1.25 billion sterling-denominated 30-year bond issue by a French energy giant attracted more than £1.8 billion in demand. Other examples include recent deals in investment grade corporate sector from the likes of Imperial Tobacco and UKPONE which saw new issue book sizes in excess of £3bn and £1bn, respectively, according to the lead managers.
Benefitting from the Supply Vacuum
The BoE’s new round of QE could exacerbate the imbalance between supply and demand and leave a hole in supply that is highly unlikely to be filled by sterling credit issuance. Over the period of QE1, government guaranteed issuance absorbed much of the capital that would have gone into gilts. That government guaranteed issuance has now stopped. We believe the lack of issuance remains a positive technical for the sterling credit market. Based on current run rates, we are likely to see just £35 billion in investment grade benchmark size issues in 2011 within a market that is £440 billion in size, whereas in 2009 we saw nearly £80 billion in issuance. But we feel that the flow of funds to credit remains positive. Market estimates for 2011 issuance point to a net decline of £18 billion (Source: Barclays Capital).
The lack of issuance in the case of non-financials is generally due to strong corporate balance sheets, undrawn credit lines at banks and the rebirth of the loan market. In the case of financials, the levels that the markets are currently trading at may make it unattractive for banks to issue significant amounts of unsecured senior paper. Regulatory uncertainty is likely staying the hand of bank capital issuance. Some issuers have come to market with covered bonds but many have chosen to issue in euro rather than sterling. This could leave the sterling credit market deprived of even average levels of new issuance during a time of high redemptions. For example, £51 billion worth of investment grade corporate bonds is set to mature in 2011 versus an anticipated total of £35billion in investment grade issuance for 2011, which ranks the second lowest year for issuance in the past 10 years (Sources: Bondware and Barclays Capital). At the same time, despite coming in from their October 2008 levels, we believe that current spreads on investment grade credit are still at overly pessimistic levels (see Figure 1). Indeed, the latest Moody’s investment grade projections point to lower rather than higher default rates. In the third quarter, Moody’s trailing 12-month global speculative grade default rate stood at 1.8%, down from 2.3% in the previous quarter. Moody’s predicts that the global speculative grade default rate will continue to remain low, ranging between 1.4% and 2.1% over the next twelve months.
Looking Ahead
So what happens after QE2? Purchases of financial assets financed by central bank money should initially increase broad money holdings, push up asset prices and stimulate expenditure by lowering costs and increasing wealth. At least this was the stated intention of the BoE when it re-embarked on QE1. Asset purchases may also influence bank lending, although this effect is not expected to be material given the current financial crisis.
More generally, policy announcements on asset purchases might carry “news” about the underlying state of the U.K. economy. Based on our forecast, GDP growth looks set to be an anaemic 0-0.5% for the next 12 months. According to the Office for National Statistics, the latest unemployment rate in the U.K. is 8.1% with substantial regional variation and the U.K. government has started to talk about what measures would be appropriate to boost economic activity in the U.K. There is clearly a major challenge in that the U.K. government has committed itself to a severe austerity plan in the life of this parliament (next elections are due in 2015). The aim is to bring U.K.’s budget deficit down to less than 1% of GDP by 2015. In addition to this, U.K. inflation has been running at above the prescribed 2% level since December 2009, with the latest figures for CPI standing at 5.2%, according to the Bank of England. That said, we do not believe that growth is set to deteriorate further from here over the longer term.
Given this anaemic economic outlook, we believe avoiding consumer-related issues continues to make sense. Instead, we prefer to focus on the strongest names across what tends to be the highly cash-generative utility and telecom sectors, which can offer attractive spreads and better risk adjusted return potential. Financials have continued on their path towards de-leveraging, both voluntarily and through regulation. Credit spreads for financials have only recently traded inside their widest levels experienced at the end of September. We believe the strongest names in the financial sector continue to offer value.
We continue to avoid metals, mining and construction sectors given the risk from M&A activity, the potential for ratings migration, volatile commodity prices and economic uncertainly. Despite our concerns with consumer-led sectors, we think shorter-dated bonds issued by auto companies offer good value given their significant deleveraging and healthy short-term cash positions.