As yields rise and central banks battle to curb inflationary pressures, much attention has focused on US and European bond markets.
For the UK, the long running distraction of Brexit – and its likely wider term economic impacts – also continue to preoccupy some market analysts.
Elsewhere, a series of leadership changes within the ruling UK Conservative Party and the short-term fallout from the ill-fated Truss/Kwarteng mini-budget of September 2022 have done little to bolster UK financial credibility on a global stage.
We see strong opportunities in the banking sector even though it was globally tested by problems in the US early last year
Yet for all this, we see some compelling strengths and attractions in a UK corporate bond market heavily supported by giant institutional investors such as UK pension funds and which is increasingly attracting a range of smaller, more retail-oriented investors.
Despite some gloomy market predictions, there are a lot of technical positives for the UK economy and its corporate bond market. Yields are rising and there continues to be strong demand and relatively low supply for these assets in what is really quite a resilient market.
We broadly see the most value in corporate bonds and credit within investment grade (IG) on a risk adjusted basis. The demand picture for investment grade credit appears strong looking forward with both institutional and retail investors attracted by high IG yields that can now exceed the dividend yields of their headline equity counterparts.
From a sector perspective, the non-cyclical industrial and banking sectors offer some particularly compelling investment opportunities in the current market.
The UK has tended to lead the rest of the world on baseline ESG disclosure
Within investment sectors, we still like non-cyclical industrial corporates. We also see some strong opportunities in the banking sector even though it was globally tested by problems in the US regional banking space early last year.
In the period since the global financial crisis, we have also seen the top tier banks increase the resilience of their balance sheets. We believe select banks now offer a large enough yield pick up to compensate for any worries or potential risk relative to some other sectors.
With responsible investment attracting increasing attention from many investors, we believe the UK corporate sector can point to a broadly favourable environmental, social and governance (ESG) score card.
From a responsible investment standpoint, the UK – as in continental Europe – has tended to lead the rest of the world on baseline ESG disclosure. Within the UK corporate sector there are a large number of companies with the resources available to invest in the right procedures and policies, even if there are some outliers.
The BoE is making good progress in curbing inflation, though this does not rule out the prospect of further market squalls
The UK corporate bond market is also somewhat lower in cyclical industrials relative to US and European sectors, with perhaps fewer obvious carbon emitters than in some other markets.
Healthy UK demand for corporate bonds continues to be heavily supported by large domestic institutional investors such as pension funds and insurers.
In terms of demand, the UK corporate bond market is dominated by an institutional buyer base. Many of these institutions are pension funds looking to ‘derisk’ their portfolios and immunise them by allocating more heavily to fixed income.
Often these strategies involve buying corporate bonds at the expense of equities or alternatives, meaning there is generally strong technical demand, particularly for longer dated UK corporate bonds.
We believe UK economic growth will be higher than some analysts predict and we are not expecting a recession
Beyond the buy-side, at a macro level, the UK has been grappling with persistently high inflation over the last 18 months. The problem, shared by several other major markets, has seen successive interventions by the Bank of England (BoE) to adjust interest rates and help curb inflationary pressures and the resulting cost-of-living squeeze.
The BoE is making good progress in curbing inflation, though this does not rule out the prospect of further market squalls and bond market uncertainty in the months ahead.
We think the BoE is nearing the peak in rates in this hiking cycle, but monetary policy uncertainty remains in the face of inflation sticking stubbornly above central bank targets and a tight labour market.
The positive environment for risk markets looks likely to last for longer into 2024 than previously expected but it could still prove to be more transitory in nature if core inflation remains sticky and monetary policy has to remain tighter for longer to ensure more permanence in the move of inflation back within central bank targets.
Despite a note of caution, we remain broadly optimistic on the investment outlook for UK corporates and the wider economy.
While the UK is somewhat vulnerable thanks to its weak trade balance and current fiscal demands, it has, to some extent, been outperforming some of the more bearish predictions we saw post-Brexit.
We believe UK economic growth will be higher than some analysts predict and we are not expecting a recession. That said, considerable uncertainty remains.
Damien Hill is senior portfolio manager at Insight Investment
