The UK credit market tells a grim tale of a looming cash crunch

(Bloomberg) — The sterling bond market is in the red, with double-digit losses and borrowers on the run.

This is alarming for businesses that need cash. They are facing rate hikes from the Bank of England, a cost of living crisis with inflation at a 40-year high and the slow legacy of low productivity. And then there are the additional fallout from Brexit. Overall, Bloomberg Economics expects the economy to shrink 0.4% this quarter.

“It creates a pretty tough setup,” said Justin Jewell, high yield portfolio manager at BlueBay Asset Management LLP. “The sterling market has been a little unloved this year, partly because of the BOE rate hikes and partly because the UK economic outlook looks the weakest of the major economies.”

A Bloomberg index that tracks top-rated sterling securities, the bulk of which are owned by UK-based companies, fell 11% this year on Thursday, two percentage points more than euro-denominated debt . The gauge’s market capitalization fell by £38 billion ($48 billion), the worst year-to-date contraction since at least 2000, going as far back as the data goes.

On top of that, the market for new sterling corporate bonds, which is much smaller than its euro and dollar counterparts, has come to a virtual standstill. Issues by UK-based non-financial companies in 2022 are just £3.78bn, the lowest since 2016 and a third of what was sold this time last year. Companies such as Matalan Ltd. have to rethink their capital structure, and financing mergers and acquisitions becomes tricky and expensive.

“UK businesses that need cash and are struggling with the inflationary environment may struggle to service debt or raise more capital or maintain operations,” said Zachary Swabe, portfolio manager at UBS. Asset Management. “As issuers of sterling refinance, they will be forced to pay higher coupons, in some cases double and in others even triple.”

Indeed, borrowing costs have soared this year, with the yield on investment-grade sterling corporate bonds climbing around 160 basis points to 3.66% in May, the highest since 2016. , according to a Bloomberg index. Returns are almost a full percentage point above their 10-year average.

A deep dive into the gauge shows that all bonds that can be measured on an annual basis are down in 2022. The biggest losers are some consumer credit, which has fallen an average of 13%. A Bloomberg index of junk-listed sterling debt paints a similar picture, with all but a handful bonds down.

“Higher borrowing costs and a tougher borrowing environment will inevitably add to the growing pressures on margins facing businesses, amid weaker consumer demand,” said James Smith, an economist at ENG. “It is fair to say that the SME space is more vulnerable, partly because they are probably more vulnerable to the higher inflation environment, but also because debt levels have increased much more substantially during Covid. .”

Sales of sterling corporate debt to domestic non-financial borrowers almost doubled in 2020 to £8.4bn, then increased again in 2021 to £10.7bn, the highest since 2018, according to data compiled by Bloomberg.

Soaring inflation and a series of Bank of England interest rate hikes to their highest level since 2009 are fueling soaring corporate bond yields, but so is the prospect of a slowdown economic growth and concerns about corporate earnings. While the government’s recent package of measures to help households cope with rising energy prices has reduced the risk of recession, growth is likely to be lackluster.

Dan Hanson of Bloomberg Economics expects gross domestic product to rise 0.3% in the third quarter and decline 0.3% in the last three months of the year. But he also says government measures will prompt the BOE to raise rates four more times this year. This would drive up corporate borrowing costs.

Market fluctuations

The threat of stagflation increases credit volatility. A measure of market swings for investment-grade sterling corporate bonds – the 100-day historical volatility gauge – is the highest since August 2020. This makes tapping into the market a challenge, and it is one of the reasons why bankers are nervous about engaging in financing transactions supporting mergers and acquisitions.

Take the Boots chemist sale, a high street staple. Before the Issa brothers, who were bidding with TDR Capital, considered pulling out of the talks, they and the rival consortium – Indian tycoon Mukesh Ambani and takeover firm Apollo Global Management Inc – had yet to secure a Binding financing agreements with banks.

One of the deterrents for lenders is the fact that the banks have a staggering $20 billion in debt they’ve taken on to fund buyouts, which they can’t get off their balance sheets because of the rising cost of money and reduced appetite for risk.

If markets weren’t so volatile, banks would likely be rushing to provide liquidity. But they have seen the difficulties their peers continue to face with WM Morrison Supermarkets Plc, which was underwritten in August when borrowing costs were considerably lower. Earlier this month, banks had to delay the sale of more than $2 billion in debt supporting the takeover of the international assets of British bookmaker William Hill Ltd.

These issues diminish the attractiveness of UK assets for private equity firms.

“The job of private equity is to buy things at the bottom of the cycle,” said UBS’s Swabe. “PE still have the luxury of time and a worsening of the UK economy will occur before they pounce.”

But for a handful of investors, falling corporate bond prices are a bargain-hunting opportunity, especially for those who think rate hikes are already priced in.

Some of the valuations are starting to look attractive, according to Paola Binns, senior fund manager at Royal London Asset Management. It’s only “if you have the ability not to lose your temper”.

©2022 Bloomberg LP

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