Sterling market resists efforts to pension it off
The ability of investors to analyse and take down a huge variety of structures in both private and public benchmark deals means sterling will continue to be a unique bond market for domestic and international borrowers — no matter what Brexit means for the UK or the rest of the world. By Philip Moore.
Jonathan Peberdy, head of syndicate at NatWest Markets in London, echoes a number of bankers when he cautions against predicting the death of the sterling bond market.
It would not be the first time. Doomsayers forecast the demise of the sterling market when the UK chose not to join the single European currency, only to see volumes surge as it established itself as a compelling alternative to core Europe, especially at the long end of the curve.
Premature obituaries were also written after regulatory changes such as amendments to annuity rules and Solvency II, which some thought would pull the rug from under the market’s feet by prompting an exodus from corporate bonds — again, especially at the longer end.
The sterling market’s demise was most recently heralded in the run-up to the referendum on EU membership last June. Volumes in the market virtually dried up in the first half of 2016, only to rebound powerfully in the second half. Much of that recovery was driven by the Bank of England’s £10bn corporate bond buying programme set out in August. But the market had recovered at least some of its mojo well before then. As Peberdy says, the 4.6 times oversubscription level for a BATS £500m five year bond that was priced exactly a week after the referendum shows the resilience of the sterling market.
Longer term issuance trends also point to the resilience of the sterling market. “Of course the dollar and euro markets are larger and more liquid,” says Gordon Taylor, head of debt capital markets at NatWest Markets in London. “But supply in sterling has remained constant, accounting for about 6%-8% of the total funding needs of corporates and financial institutions over the last few years. So to say that sterling is a market in decline is not borne out by the issuance statistics.”
Marco Baldini, head of European bond syndicate at Barclays in London, agrees that the sterling market has been resilient. But he says a range of pressures have combined to change its structure, probably permanently. The most obvious being the competition and superior scale of overseas markets, which encouraged many UK-based funds to expand their horizons well beyond the sterling market. “UK money tends to be more ruthless in its search for value in euros and dollars, which has removed some of the natural demand for sterling assets,” says Baldini.
Stuart Montgomerie, head of DCM and syndicate at Santander in London, says the contraction in liquidity after the crisis of 2008 and 2009 is also set to stay. “Given the wave in regulation we saw after the crisis, banks are unlikely ever to return to providing the liquidity levels they did in the past,” he says.
There are other ways in which the sterling market’s potential is constrained. One is that it lacks a natural large issuer base, with sterling accounting for only a modest proportion of the funding requirements of the largest UK firms.
There has traditionally been no shortage of other issuers to compensate for this, with international borrowers in the corporate and FIG sectors bringing depth and diversity. “For non-UK borrowers the sterling market remains a very good source of diversification and arbitrage,” says James Marriott, head of FIG debt capital markets at UBS in London.
Much of the appeal of the sterling market, for international and local issuers, is the size and sophistication of the investor base. “To the outside world, the sterling market may have looked somewhat dysfunctional and illiquid over the last few years,” says Montgomerie at Santander. “But we still have an extremely large and sophisticated insurance and pension fund industry. With pension funds still needing to de-risk their overall exposure by rebalancing their allocation between equities and fixed income, I see local institutional demand for sterling remaining solid.”
Data on pension funds’ asset allocation supports this confidence in future demand patterns. According to Willis Towers Watson, in the last decade pension funds in the UK have increased their exposure to fixed income, from 24% in 2006 to 36% in 2016, although in 2011 it reached 39%. Nevertheless, UK pension funds remain overweight in equities, even though they have reduced their exposure from 64% in 2006 to 47% in 2016.
Pension fund demand provides support for issuance across the yield curve. This support has weakened, but sterling is still seen as fertile territory for long-dated funding. “Structurally, the pension market in the UK continues to lend itself to demand for long-dated issuance which institutions in the eurozone are less likely to support,” says Keval Shah, head of bond syndicate at Lloyds Bank in London.
Peberdy at NatWest Market says since 2014, 37% of corporate supply in the sterling market has been in maturities of 15 years or longer, versus just 5% in euros.
Whether sterling’s competitive advantage at the longer end of the curve can continue is open to question, given regulatory changes that are encouraging pension funds to re-evaluate their asset allocation. At the same time, there is some doubt over how insurers’ appetite for credit in general, and longer dated credit in particular, will develop in light of the punitive capital requirements for lower rated bonds prescribed by Solvency II.
This dynamic is reflected in the sterling curve. “Changes in pension regulations together with Solvency II have reduced demand for duration,” says Barry Donlon, head of capital solutions at UBS in London. “The sterling credit curve was flat, with limited distinction between spreads at 10 and 30 years. Today, this spread could be 50bp or more for investment grade corporate borrowers. This is why 30 to 50 year tranches, which used to be very common in sterling, are now so rare.”
Another feature of the sterling investor base is its increasing concentration within a small group of deep-pocketed and powerful institutions. This has been driven by the consolidation in the UK fund management industry.
This may mean some large institutions are at or near exposure limits for regular borrowers. Bankers report that if there has been an erosion in domestic demand, much of this has been counteracted by increased buying from overseas, especially for UK bank debt. “While there has been consolidation among UK real money investors, there has been a broadening of the investor base with increased participation in sterling deals from European investors,” says Marriott at UBS.
The Brexit vote does not appear to have had a negative impact on this overseas demand. “Non-UK participation in sterling transactions dipped in the first half of 2016 but has since rebounded and is now consistently in the 15%-20% range by allocations,” says Peberdy at NatWest.
The adaptability and inventiveness of the UK institutional investor base has helped make the UK a workshop for much of the innovation in the capital market outside the US. “The UK market has consistently shown itself to be one of the most open-minded and forward-thinking in the world,” says Shah at Lloyds.
Others agree. “Sterling has one of the most developed inflation-linked corporate markets in the world,” says Baldini. “It has also seen a series of whole business securitization bonds and infrastructure-type deals since the 2000s, and today we often see university and housing association transactions. The ability of investors to analyse and take down a huge variety of structures in both private as well as public, benchmark deals continues to make this a unique market.”
Peberdy adds: “Since 2014 we have seen about £14.4bn of structured supply in areas such as whole business securitizations, compared with €6.5bn in euros. Whether it’s for water companies, airports, pubs, or companies with strong cashflows like RAC or AA, the sterling market has been consistently innovative.”
Brexit’s impact on the market remains as unclear as the broader economic repercussions. “A sterling-denominated UK pension portfolio invested in UK credits is probably the least impacted by Brexit,” says Donlon at UBS. “I haven’t heard from any of our clients that it is more difficult to raise funding since the referendum.”