Scottish Widows Sees Corporate Bond Rally Fizzling: U.K. Credit

Investors are cooling on sterling corporate bonds as the Bank of England and the European Central Bank prepare to pursue diverging monetary policies.

As ECB President Mario Draghi primes investors for fresh stimulus next week to spur the euro-region recovery, BOE officials are moving closer to an interest-rate increase amid growing evidence that the U.K. economy is gathering momentum.

After more than five years of record-low borrowing costs, signs of a shift are emerging at Britain’s central bank. For some officials, the case for a rate increase is becoming stronger, minutes of their meeting this month recorded. Investors are pricing in an increase in the 0.5 percent benchmark rate by April next year, Sonia contracts show.

“Over the summer, I’d be nervous about total returns in the sterling credit market,” Luke Hickmore, who helps oversee about 30 billion pounds ($50 billion) of corporate debt at Scottish Widows Investment Partnership in Edinburgh, said in an interview.

Corporate bonds climbed this year as low government bond yields and an economy on course for its best year since 2007 led investors to buy risker assets. Pound investment-grade debt returned 4.4 percent this year, according to Bloomberg World Bond Indexes.

‘When, Not If’

“It’s a question of when, not if” the BOE raises rates, Ketish Pothalingam, a fund manager at Pacific Investment Management Co., said in an interview. “You have the added complication of an election in the way,” he said, referring to the U.K. general election next May that analysts say may again fail to produce an outright winner.

The U.K. economy expanded 0.8 percent in the first quarter and is forecast by the International Monetary Fund to grow faster than any other Group of Seven nation this year.

That contrasts with the 18-nation euro region, where growth was just 0.2 percent as France stalled and economies from Italy to the Netherlands shrank. According to a Bloomberg survey, the ECB will cut the benchmark rate by 10 basis points to 0.15 percent on June 5 and may reduce the deposit rate to below zero, in effect charging banks for parking cash with it overnight.

The prospect of more stimulus, with ECB officials saying that asset purchases, or quantitative easing, could even be deployed if needed, has helped to boost euro-area bonds. Investment-grade debt has gained 3.9 percent this year.

Risks Hardening

In the U.K, the recovery has hardened expectations that Britain will be the first G-7 central bank to raise interest rates since the ECB in 2011. At least one of the nine Monetary Policy Committee members could vote for a rate increase by the summer, say some economists. The BOE, led by Governor Mark Carney since July, last raised borrowing costs in 2007, before the financial crisis tipped Britain into a record recession.

“The market is already pricing in rate hikes in the first half of next year,” said Shikhar Sethi, a credit analyst at Royal Bank of Scotland Group Plc. “Better data will reinforce those expectations and send rates higher, causing U.K. credit to underperform euros.”

Sterling bonds may also be hit by new rules allowing retirees to spend their pension savings as they wish instead of having to buy a lifetime income, as providers of so-called annuities require less long-dated debt to match their liabilities, according to Pothalingam. He says bonds with maturities of five to 10 years offer the best value.

Rate Forecast

Not everyone is souring on U.K. debt. Azim Meghji, head of U.K. fixed income at Santander Asset Management, which oversees 19.7 billion pounds, says the compression in European credit spreads has aided sterling since March and may continue to do so, providing the BOE continues to indicate rates will stay low.

At SWIP, Hickmore predicts the BOE will raise rates by year-end. The 10-year government bond yield, currently about 2.6 percent, is forecast to end the fourth quarter at 3.3 percent, the median of forecasts compiled by Bloomberg show.

“I think the risk of the 10-year getting higher is very strong, the risk of modestly flattening curve is very strong and credit is not going to give enough to compensate that move,” Hickmore said.

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