We are often asked if there are opportunities in Sterling-denominated high yield bonds. As ever, the answer is nuanced and not black and white. So, in the context of what looks to be an increasingly messy Brexit and sustained weakness in Sterling (down 11% since the peak in April) we thought it worthwhile to explain our logic in some of our preferred Sterling bonds. Indeed, with a global remit there is no shortage of opportunities so why make the case for these issuers?
Our view is that Sterling-denominated high yield bonds “generically” are very cheap at present. What do we mean by this? We see a number of examples where bonds issued by the same company, with the same maturity, and same level of protection for bondholders, are cheaper purely because they are denominated in Sterling. For example, there are currently two bonds issued by the supercar producer McLaren which are identical in every way (covenants, maturity date, etc.) except that one is in Sterling while the other is in US Dollars. The pricing has become so dislocated that, any which way, the Sterling bonds are cheaper. In absolute yield terms the Sterling bond pays more than the US Dollar bond. This is despite the fact that, in a currency-hedged portfolio investors actually get paid more for owning a Sterling asset than a US Dollar asset. We summarise this incremental return below:
|Mclaren GBP bonds||McLaren USD bonds|
|Local Currency yield:||5.94%||5.89%|
|Effect of Sterling hedge:||+1.57%||–|
Simply put – for the same fundamental risk an investor can realise a 1.6% higher annual yield by owning the Sterling bonds over the US Dollar. This very pronounced dislocation is an illustration of why we believe unconstrained investors can benefit from investing in Sterling-denominated high yield bonds (and fully hedging their £ exposure).
Of course, a clear concern for UK based companies is the risk that they may be hurt by a further weakening of the Pound. For McLaren, of course, with production based in the UK their costs will be cheaper relative to € or $ based manufacturers. (Good news, the McLaren’s looking cheaper than the Ferrari!)
Similarly, how would a hard Brexit affect other issuers which we believe offer value? We favour companies that would be unaffected or benefit from a weaker £ such as those that compete for sales domestically with foreign imports and/or export globally (such as McLaren). For instance, the UK based holiday operator, Center Parcs benefits from a weaker Sterling as UK customers find they can get more “bang for their buck” (or “power for their pound”?) by staying in the UK rather than traveling abroad.
There are other businesses that have a domestic customer base and have a strong embedded place in the economy. Many of them have traded well throughout the recession following the global financial crisis and we are confident that they should be able to weather any economic weakness that would result from the Brexit process. An example of this is Together Finance which occupies a unique (and very profitable) position in the UK financial ecosystem through its niche mortgage lending. It weathered the 2008-2009 Global Financial Crisis with remarkably little difficulty. Indeed, during the crisis the company’s annual loan losses only got to around 1% – leaving us very comfortable with the issuers risk profile should 2019’s Brexit prove challenging.
Most of the focus in recent months in the Sterling market has been around distressed issuers, especially in the retail arena (i.e. House of Fraser bonds are set to receive a fraction of their face value). This is very far removed from the £ high yield that we are focussed on at Kames, where our team’s approach continues to be to seek the best high yield issuers and remain “unconstrained”. This translates as remaining flexible, being able to identify opportunities and banking profits, depending on where £ high yield credit trades relative to € and $ issuers. This flexibility also means that, should we view Sterling-denominated bonds as no longer providing compelling value, we have the ability to reduce our Sterling exposure to a zero-weight.