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Ketish Pothalingam, Luke Spajic
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.
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.
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