Brexit: Why sterling high yield bonds are at risk

The M&G bond team offer their perspective

Most of the early investment commentary around the Brexit vote has been about the impact on UK government bonds (the yield of which has fallen below 1% for the first time in their history); the pound (which has fallen 20% against the US dollar); and the stock market (which initially fell by almost 10%, before going on to achieve a 12-month high).

The sterling high yield bond market hasn’t made the headlines – possibly because of the fairly benign reaction to the referendum result so far. The market is 2% lower in price terms since the vote.

One explanation for the muted market reaction, according to the M&G bond team, could be the expectation for further monetary easing in the near term. The Bank of England is widely expected to lower interest rates over the summer and possibly restart its quantitative easing programme of buying bonds once again.

Of course, monetary policy can only do so much to support a deteriorating economy and chancellor Osborne’s less austere approach to fiscal policy is also providing some hope that a possible UK recession would be a shallow one.

There could be other reasons why the reaction in the high yield market has been relatively benign. For instance, like the FTSE 100 (the UK’s stock market index of our largest companies), the high yield bond market is not a very good reflection of sentiment surrounding the UK economy. This is because there is a significant number of international issuers that issue high yield bonds in sterling. For example, Anglo American, Gazprom, Petrobras and Enel are all constituents of this market.

According to M&G, domestically-focused businesses, that are more dependent on the economic cycle and that source their inputs from overseas (for example clothing retailers) are the most vulnerable. Whereas, exporters of goods and services to non-EU markets may actually see a small benefit. This is again very similar to the story of the FTSE 100 and is why its international constituents have fared better than more domestically orientated medium and smaller UK companies.

However, M&G believe that most high yield bond issuers will see a negative impact, while the number of companies that could benefit from Brexit constitutes a small minority. Furthermore, when relative value is taken into consideration, the potential “winners” that trade cheaply are not without other risks. For example, Aston Martin is a potential winner as a UK-based international exporter and is not dependent on the European mass market. However, it has its own challenges as a small, capital-constrained niche producer in a very competitive market. Brexit is unlikely to outweigh existing challenges for the business.

Given the muted market reaction, and the likelihood of some extended fundamental challenges, M&G believe that rather than trying to back winners right now, the more interesting strategy is to sell or reduce exposure to the potential losers.

Given the complexity of the bond markets, strategic bond funds remain one of the most popular fixed income asset classes amongst UK investors. Managers of these funds decide on their allocation to government, investment-grade and high yield bonds, and can adjust how much they invest in each, depending on their views of the markets. M&G has one Elite Rated strategic bond fund: M&G Optimal Income.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views of the author and any people interviewed are their own and do not constitute financial advice.