Bond markets since Brexit A snap back in risk appetite, but uncertainty persists

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Paul Jennings
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1 For Investment Professionals only Bond markets since Brexit A snap back in risk appetite, but uncertainty persists August 2016 The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is included, please note that this is not a guide to future performance. Bond markets in the UK and Europe have largely calmed following the Brexit vote in June and corporate bonds have rebounded from their short-term weakness immediately after the result. Government bonds continue to be beneficiaries of high demand for safe assets, which is keeping yields at record lows. The focus on central bank action has resumed, but the still high degree of uncertainty surrounding the future shape of Brexit may create further volatility as events develop. UK and European bond markets have rallied strongly in the weeks since the UK referendum. Yields on government debt have hit new record lows as investors have sought safe havens, while corporate bonds have responded positively to a lack of new negative developments as the fear of a broader crisis has subsided. However, uncertainty remains high as a lack of clarity ahead of the vote has been swiftly replaced by uncertainty regarding the timing and specifics of the Brexit agreement. In the short term, the focus has returned to central bank policy. In Europe the ongoing European Central Bank corporate bond purchases continue to underpin pricing of eligible securities, while pledges from the Bank of England immediately after the vote result helped stabilise UK markets. Growing expectations of fresh monetary easing in the UK are now supporting gilts and Sterling corporate bonds. Prior to the vote, markets had expected that the Bank of England might be tightening rates within a year, but the next move is now anticipated to be a cut. The bank surprised many by keeping rates on hold at its July meeting but is now widely expected to take action in August as the after-effects of Brexit filter through into economic indicators. Comments from Martin Weale, a Monetary Policy Committee member, backing an interest rate cut in August and stimulus measures have helped to strengthen gilts and Sterling corporate bonds in late July. UK government bonds: yields collapse, but likely volatility may create opportunities Gilts experienced a traditional flight to quality in the wake of the vote that pushed 10-year yields below 1% for the first time in history on 27 June, where they have remained since. Gilts are well supported across the curve and we expect this to continue, reflecting the UK s control of its currency and its very long-dated debt profile. Downgrades by the major international credit rating agencies in June after the vote have not deterred investors or had a material impact. Markets regain composure after initial sell-off Across capital markets, the initial reaction to the referendum outcome was fairly uniform with the risk premium associated with financial assets rising and prices falling. Currency and equity markets were the focal points in the immediate aftermath: sterling fell 11.5% against the US Dollar from 23 June close while the FTSE 250 (a better reflection of domestic UK earnings than the FTSE 100) was down 12% on 24 June. The negative reaction was not solely a UK event peripheral European stock markets were also hard hit, as were equity indices further afield including in the US. However, indices have since recovered the lost ground while market volatility, though initially high, has since subsided. Only Sterling is still significantly weaker than prereferendum, closing at versus the US Dollar on 26 July, compared with on 23 June. The UK has run a large current account deficit in recent years and the currency s strength going forward may hinge on the economy s capacity to attract the same degree of overseas investment as in the past.

2 UK 10 year gilt yield (%) UK 10 year gilt yield (%) The risk of a recession in the UK, or at least a lower trajectory for economic growth over the next few years, has increased following the vote, given expectations of lower business investment spending. However, the economic situation is highly unlikely to become severe enough for the UK s solvency to be called into question and this combination of greater risk and strong solvency is bullish for gilts. A couple of factors may affect this: firstly, at the current levels, gilt yields are pricing in rates being cut to close to zero, whereas if the UK economy remains relatively stable then these valuations are very high. Secondly, the weakness of Sterling and a potential increase in protectionism in the UK could potentially lead to higher inflation, which is not favourable for fixed rate gilts UK 10 year gilt yield one month on Title: Arial bold size 10. Rounded rectangle height 0.8cm UK downgraded by major credit rating agencies Jun 22-Jun 29-Jun 06-Jul 13-Jul 20-Jul 27-Jul UK 10 year gilt yield five years We anticipate higher gilt market volatility over the coming months as political and economic events develop which should favour our value-based investment style. Trading ranges in the relationships we trade could potentially become much larger than they have been in the past, which could create significant investment opportunities. European government bonds: in the red Government bonds across Europe have experienced robust demand from investors seeking safety following the vote result, which has pushed an increasing volume of bonds into negative yields. Pre-referendum jitters caused the yield on the benchmark German 10-year bund to drop into negative territory for the first time on 16 June, while on 24 June they touched -0.11%. On 13 July Germany became the first Eurozone country to sell 10-year bonds at a negative yield, at -0.05%.

3 Credit spread (Libor OAS, bps) Yield (%) Finally, on 5 July the yield on the 50-year Swiss government bond turned negative, which took the entire Swiss yield curve into negative territory Negative territory: Switzerland government yield curve 3M 6M 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 12Y 15Y 20Y 25Y 30Y 40Y 50Y -1.2 Corporate bonds: markets look to central bank panacea once more Corporate bond yields were little changed following the vote result, as credit risk premia were pushed wider by heightened risk aversion, offsetting the contraction in government yields. Still, this effect was significantly less extreme and much shorter-lived than in January and February, when risk aversion peaked after several months of concerns around global growth, commodities prices and Chinese economic strength that dominated investors decision-making. Sterling credit unsurprising reacted more strongly than Euros, but in both markets the impact was short term. 250 Sterling investment grade credit spreads 225 Brexit Fears over global growth outlook and weak commodity prices Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Source: M&G, Bloomberg, BofA Merrill Lynch Sterling Corporate & Collateralised Index, as at 29 July 2016 The flare-up in risk aversion reversed rapidly as immediate concerns over the impact of Brexit on the UK economy and cohesion of the European Union abated. With no historical precedent for pricing such an event, markets appear to have returned to a business-as-usual environment, at least for the present. Market direction has been guided by the near-term impact of central banks monetary policy activities once again, resulting in a sustained rally and a snap back in spread levels throughout July. In Sterling, this centres upon expectations of a Bank of England interest rate cut and potentially even the launch of further asset purchases to ease monetary policy. In the Euro market, the focus remains on the European Central Bank s purchases of investment grade corporate bonds through its Corporate Sector Purchase Programme (CSPP), which continues to put a floor under eligible securities.

4 Credit spread (Libor OAS, bps) Euro investment grade credit spreads Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Source: M&G, Bloomberg, BofA Merrill Lynch Euro Corporate Index, as at 29 July 2016 An effect of the ECB bond buying in the Euro market has been to create pockets of relative value in noneligible paper, as well as in non-euro markets such as US bonds. However, the CSPP as in other markets affected by central bank intervention also increases the likelihood of securities becoming mispriced as fundamental credit risk becomes a secondary consideration. Such pricing anomalies can create investment opportunities for value investors such as M&G and we continue to monitor these. The initial post-vote turbulence identified a few sectors as being vulnerable, such as financials and property issuers. These sold off to a greater degree than the wider market, reflecting concerns that Brexit could weaken UK and European GDP growth with consequences for unemployment, house prices and corporate default rates that could negatively impact banks loan books and consequently their capital ratios. The shortterm sell-off affected high-quality, well-capitalised banks as well as their weaker peers, but these bonds have also benefited from the wider market rally and rebounded in recent weeks. Euro-denominated eligible asset-backed securities (ABS) also continue to be supported by ECB buying, in contrast to UK (Sterling) ABS and in particular UK residential mortgage-backed bonds, which now trade at wider spreads than prior to the vote. Heightened uncertainty points to volatility ahead We do not yet know if the referendum result will have a short lifecycle impact or whether the profound changes that the UK and Europe now face will be delivered over a protracted period of time, along with further bouts of volatility. We suspect the latter as a result of the myriad of possible outcomes from future negotiations. It adds further ambiguity to an already uncertain outlook, given the potential for political change resulting from events such as Italy s referendum on constitutional reform later this year and elections in the US, France and Germany in Though central banks continue to project calm and implement more monetary easing, their actions also have unknown and as yet unresolved implications. Still, financial markets are well accustomed to volatility, whether economically or politically driven. Generally, these episodes have short life spans with limited long-term effects on the companies in whose debt we invest. Periods of risk aversion are the very times in which our long-standing approach to investing has proven its worth; looking through the short-term noise to the long term, we have often found those investment opportunities that go on to deliver the outperformance our clients seek. As ever, we continue to look for attractive opportunities on a security-by-security basis, with the patience to withstand short-term volatility in companies in which we have confidence.

Richard Ryan Senior Fund Manager Richard joined M&G Investments in 2001 and is a senior credit fund manager looking after Pan European credit strategies, absolute return strategies and fixed income

Before this, he worked for Dresdner Kleinwort Benson in the Credit Products Group trading corporate bonds. Richard graduated from Southampton University with a degree in Economics.

5 Richard Ryan Senior Fund Manager Richard joined M&G Investments in 2001 and is a senior credit fund manager looking after Pan European credit strategies, absolute return strategies and fixed income asset allocation. Prior to joining M&G, Richard worked for Nomura Asset Management as an institutional fixed income fund manager. Before this, he worked for Dresdner Kleinwort Benson in the Credit Products Group trading corporate bonds. Richard graduated from Southampton University with a degree in Economics. Miles Tym Fund Manager Miles joined M&G Investments in January 2009 as a senior portfolio manager specialising in Government bond and macro fixed income mandates. Miles worked briefly as an accountant and a trader on the LIFFE floor before joining the investment management industry in He spent the next eight years of his career managing both Government and corporate bond portfolios for Alliance Capital. Miles joined Morley in 2004 with a brief to specialise in Government bond portfolios. Miles graduated from Cambridge University in 1993 with a BA Hons in Economics. For more information contact: Andrew Swan +44 (0) andrew.swan@mandg.co.uk John Atkin +44 (0) john.atkin@mandg.co.uk Henry Barstow +44 (0) henry.barstow@mandg.co.uk Sunita Dey +44 (0) sunita.dey@mandg.co.uk institutional.clients@mandg.co.uk The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Where past performance is included, please note that this is not a guide to future performance. For Investment Professionals only. This guide reflects M&G s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. Past performance is not a guide to future performance The distribution of this guide does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Reference in this document to individual companies is included solely for the purpose of illustration and should not be construed as a recommendation to buy or sell the same. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. M&G Investments is a business name of M&G Investment Management Limited and is used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London EC4R 0HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority.0746/MC/0818 MDII

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