Why It Has Been a Sterling Year for Corporate Bond Markets

The sterling corporate bond market is small, but producing outsize returns

By Richard Barley

    Corporate bond markets are betting on Bank of England support. Photo: Bloomberg News


Corporate bonds are putting in another vintage performance. Perhaps surprisingly, the U.K. is a leading light—benefiting despite Brexit in part from a bet on Bank of England support.

Investment-grade sterling corporate bonds are up nearly 13% year to date in local-currency terms, according to Bank of America Merrill Lynch indexes, outpacing the U.S. market, up 9.1%, and euro-denominated debt, up 5.9%. The market had a Brexit blip, but the steep drop in underlying government-bond yields limited the pain—although for foreign investors, the plunge in the pound has hurt a lot. Still, since the vote, corporate bond yields have fallen relative to gilt yields.

The U.K. market ticks a lot of boxes. First, investment-grade corporate bonds are winners given the search for yield and uncertainty about growth. The sterling market offers an average yield of 2.4%.

Second, the U.K. market is unusual in that it contains a lot of long-dated bonds. Indeed, 45% of Barclays BCS 5.10 % ’ sterling corporate bond index matures in 10 years or more, versus 29% for U.S. corporates and less than 10% for Europe. Duration is powering returns here.

 
 And third, investors may be betting on the BOE buying bonds. The European Central Bank started buying corporate bonds in June; the bonds it is targeting have rallied, and now the laggards are starting to catch up, Citigroup C -0.61 % strategists note. The gap between yields on euro-denominated nonfinancial corporate bonds and German government debt has narrowed 0.4 percentage point this year.
After July’s inaction, expectations have built for this week’s BOE meeting. That has been spurred by policy makers like Andrew Haldane calling for a “muscular” easing package and former hawk Martin Weale shifting stance on stimulus and noting that asset purchases could be effective.

That said, the BOE and the ECB face different situations. The fragmented nature of eurozone government bond markets constrains the ECB’s bond-purchase program. The BOE doesn’t face that worry. Indeed, back in 2009, the BOE briefly bought corporate bonds but abandoned the scheme as it ramped up purchases of gilts—where it could deliver a bigger program more quickly.

A big problem for both the BOE and investors is a dearth of bonds. The Barclays corporate index contains £285 billion ($377.03 billion) of bonds, making the market a relative minnow. It has hardly grown in recent years. That has been to investors’ benefit, helping to support prices.

But the small size of the market makes it vulnerable to prices getting out of whack if a big buyer steps in. Investors might get a boost to returns—but they will get new worries too.

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