This article was taken from the Summer 2023 issue of 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
As we readjust to a world of higher interest rates, thoughts are turning to how this will impact debt and refinancing. You will no doubt be acutely aware of this if you are holding a fixed-term mortgage due for renewal in the near future. Debt obligations comfortably taken on when base rates were below 1% are now bearing a substantial increase in interest when the time comes to refinance. In conjunction with lenders, the Government has moved to protect homeowners from repossession, including by providing a period of interest-only repayments for struggling borrowers.
Conversely, savers will be pleased to see returns on their cash starting to tick up and investors can find some attractive yields that would previously have only been available from the most distressed debt just a couple of years ago. There are many articles explaining how this is affecting the housing market, so let us also examine the impact on corporate bonds.
Firstly, it helps to understand why and how companies issue bonds. They may aim to raise capital for an expansion or new project, or to maintain their expenditure. By issuing debt rather than equity, they avoid diluting the ownership of the company. Any company can issue a bond, whereas listing on a stock exchange comes with certain criteria and regulatory obligations. For this reason, the global bond market is significantly larger than the global equity market. In issuing a bond, a company will enlist the help of a specialist bank. The company’s creditworthiness is then determined, and the prospective bond is taken on a roadshow to potential investors. Thus, the coupon is decided based on likelihood of default and the appetite from investors, and the bond is taken to market.
Following the Global Financial Crisis in 2008/09, interest rates were slashed and remained low until relatively recently. Many bonds were issued in this period as companies sought to capture and lock in the opportunity to borrow at exceptionally low rates. In 2021, when rates were at rock-bottom, the high-yield bond market in the US grew to a record US$1.55tn as issuers took advantage of low borrowing costs. Unsurprisingly, as rates began to climb again in 2022, issuers pulled back somewhat and the market cooled, falling by US$196bn from its peak. Year-to-date, new high-yield issues have been very low, and the market has been driven predominantly by refinancing.
A sudden return to normalised interest rates presents challenges to some bond issuers. If they are over-leveraged, refinancing will be difficult. Earnings and margins, meanwhile, will be compressed as the new cost of servicing debt jumps. One recent and prominent example is heavily leveraged utilities provider Thames Water, where investors have questioned its capacity to pay back gross borrowing of £15.9bn. More than half of this debt is inflation-linked, with accounts from its parent company showing that weighted average interest on this debt has rose to 8.1% from 2.5% the previous year. This huge leap in its borrowing costs has spooked markets and sent its lower ranking bonds into distressed territory, with one issue maturing in May 2026 falling by more than 35 points.
A large-scale sell-off of UK gilts has seen capital values fall, raising yields to levels not seen for a long time which some investors may find very enticing. As UK gilts are considered the closest thing to a credit ‘risk-free’ investment, investors will demand a premium from corporate bonds to compensate them for the additional risk they are taking. This difference in yield between a comparable gilt and corporate bonds is known as the credit spread. With two-year gilts offering a yield in the region of 5%, investor expectations from corporate bonds are much higher than we have previously seen.
With attractive yields returning, interest from investors has picked up. Bond Exchange Trades Funds (ETFs) across Europe saw net inflows of €4.3bn in May of this year. Similarly, other bond funds also saw strong take-up in the same period. Chief Executive of the Investment Association, Chris Cummings, said: “Caution was the theme of the month, with Government Bonds seeing strong inflows. This is not surprising given concern about potential global recession and ongoing conflict in Ukraine.”
Demand is strong for quality corporate bonds. This is neatly illustrated by the US$7bn of investor funds chasing a US$750m issue of a perpetual bond from Abu Dhabi Islamic Bank. Initially priced with an attractive 7.25% coupon, the bond nevertheless moved to trade at a 4% premium. Investors were tempted by its low gearing, healthy balance sheet and government backing. Morningstar data shows that in the first quarter of the year sterling corporate bond funds experienced inflows of more than £1bn. There are attractive yields on offer even for cautious investors. Quality government and corporate debt held to maturity could provide yields that were unthinkable in recent years, for comparatively low risk.
With the twin tail winds of opportunity and caution, fixed interest is undergoing something of a renaissance. Creditworthy issuers are offering attractive yields. In the years following the Global Financial Crisis, equities dominated many portfolios. With fixed interest yields so low, and even occasionally negative, a common market acronym was TINA – There Is No Alternative – to describe the predominance of equities in generating returns. That era finally looks to be over. For a sector formerly perceived as staid and low yielding, maybe now is the time to get excited about bonds.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.