Navigating bonds post pandemic

Will UK rates turn negative?

The UK Treasury issued £3.75bn of July 2023 of gilts at a yield of -0.003%, the first sub-zero rated issue, on 20 May. Will negative yielding bonds, as seen in much of Europe, become a common feature in the sterling bond market? This very much depends on the scale and length of the COVID-19 crisis and preferred response of the Bank of England (BOE).

For now, two to four-year gilts have a sub-zero yield and are pricing in a slight possibility of a negative base rate in the future. The pricing was spurred by recent comments from BOE members, such as governor Andrew Bailey. He said that “we do not rule things out as a matter of principle”. Additionally, deputy governor Dave Ramsden thinks that it would be “perfectly reasonable to have an open mind”, when it comes to negative rates.

Potential drawbacks

While the headline inflation rate is only 0.8%, the prospect of record unemployment rates and a slump in retail sales could justify further rate cuts.

That said, the central bank is aware of the possible drawbacks of negative rates, such as the detrimental effects on savings and bank profitability. For instance, lower rates have only partly been passed on to households so far, with mortgage rates being sticky. The European Central Bank had also failed to revive inflation using negative rates even before the pandemic.

A rate cut to 0%, or lower, in the existing term-funding scheme and additional quantitative easing (QE) seem to be likely options. However, negative rate policy could be revisited and should not be ruled out given the additional uncertainty around Brexit.

The Fed can’t control everything

Negative rate policy is being debated much in the US. But the rate curve, compared to the UK, has a relatively normal slope that does not suggest sub-zero rates in the short term. While US Federal Reserve (Fed) governor Jerome Powell has not ruled out negative rates, he seems more averse to them. He recently said that they are “probably not an appropriate or useful policy” and that the effectiveness of negative rates is “very mixed”.

The Fed has bought roughly $2tn of US treasuries and mortgage-backed securities in the last two months through its quantitative easing programme. While the pace will likely slow, aggressive bond buying will remain a preferred tool. As a further step, the central bank could introduce “forward guidance” or even more active yield-curve control at various points of the curve.

Since the significant drop in the US ten-year rates in March, yields have started to increase, to above 0.8%, in the latest move. Market participants are trying to calibrate the risk between the low, or even negative, rates induced by a recession and the risk of significant rate rises resulting from the vast amount of US government debt issuance. This year the debt deficit is expected to rise to approximately $4tn and remain at over $2tn next year.

US bond demand is dead, long live US bond buyers

The debt deficit has so far been covered by the issuance of shorter dated treasury bills. The composition of the bonds will soon likely include longer maturities that have been underpinned by the recent US 20-year treasury issuance. Will demand keep up with the large supply?

The Fed has already decreased momentum and will taper at some point. However, demand should stay elevated among institutional investors (locking in yields), central banks (managing currency) and households (higher saving rates).

A relatively steep curve may be a likely scenario result further out. But disinflationary (lower trending inflation), or even deflationary (falling prices), risk will likely dominate in the foreseeable future. Even if US output returned rapidly to around 90% of pre-crisis levels, the recession would be still be much worse than seen during the financial crisis in 2008. While the bond market may play a role in a reflationary scenario, yields will likely stay low over the medium term.

Reassessing BBB bonds

Investment grade bonds with medium to longer maturities seem reasonable alternatives to government bonds in this environment. But given record debt levels and the lack of cash flow to maintain the servicing of debt, the risk of downgrades has increased significantly. Selection will be key.

Considering BBB-rated bonds in order to achieve higher yields is usually a sensible option for investment-grade debt in a low-growth environment. However, at a time of no growth or contracting output, this strategy may need reassessing. Net debt of almost three-times operating earnings has been seen in the segment and interest coverage ratios are likely to implode when earnings decline.

Rating agencies are trying to look “through the cycle” and refrain from immediate rating actions. That said, this does not prevent large-scale downgrades should average credit measures deteriorate. S&P Global Ratings reckons that $385bn of non-financial corporate bonds in the US and Europe, the Middle East and Africa are at risk of being downgraded to non-investment grade status. Two years after the 2008 crisis, 20% of BBB bonds had been downgraded to junk.

Beware downgrade risk

This time around the amount of BBB-rated bonds in issue is four times as high as in 2008. When trying to identify the potential fallen angel pool (bonds downgraded from investment grade to high yield) investors should first screen for BBB-rated bonds (with a negative outlook in particular) and those trading already like BB-rated and split-rated bonds (where they are rated high yield by one agency and different rating by another). In these three buckets, risk of downgrade is particularly high (see chart) and investment grade mandated portfolios should be aware of the elevated downgrade risk.

Price action (or higher yield spreads) is usually pre-empting rating action. In the wider US investment grade index, of over 3,000 bonds, around 230 bonds are already trading wider than 480 basis points, the average of BB-rated bonds. Rating unconstrained and more actively run mandates can take advantage of respective pricing. As always, selection is key. Investment grade constrained mandates will need to adapt for the new world and act even more prudently than in normal times when considering BBB-rated bonds.

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