What Does UK Downgrade Mean for Bond Investors?

Standard & Poor and Fitch have cut the UK's credit rating, soon after the nation voted to leave the EU. How does it affect bond investors?

Karen Kwok 30 June, 2016 | 4:17PM
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Rating agencies Standard & Poor and Fitch Ratings have downgraded the UK’s credit rating following the Brexit vote. S&P lowered the rating of the UK to ‘AA’ from ‘AAA’ and said the outlook remained negative, while Fitch Ratings downgraded UK ratings to ‘AA’ from ‘AA+’.

This means that both ratings agencies believe the UK is more likely to default on its debt and not pay investors in gilts their capital than this time last week. Although the UK still holds a high grade rating the downgrades send a signal to the rest of the world regarding the economic outlook for the UK following the referendum result.

The rating agencies expressed their concerns over UK’s uncertain outlook, as businesses defer investment spend and consider the changes to the legal and regulatory environment between the UK and the European Union expected over the next two years.

Banks Take a Blow

Credit rating agency Moody's has also downgraded the outlook for the UK banking sector from Stable to Negative. It downgraded the ratings outlook on UK 12 banks and building societies. These include Barclays (BARC), HSBC Bank (HSBA), Santander UK (SANB), Coventry Building Society, Leeds Building Society, Nationwide Building Society, Nottingham Building Society and TSB Bank.

Rating Downgrade Warning Before Brexit

Rating agencies had previously warned that a Brexit vote could put pressure on the UK ratings. Bryn Jones, head of fixed income at Rathbones explained that this is because the UK relies on foreign director investment to fund its large current account deficit.

The UK’s current account deficit remained close to a record high at £32.6 billion, in the first quarter of 2016, according to the Office of National Statistics.

Nick Gartside, chief investment officer of fixed income at JP Morgan Asset Management said the UK rating downgrade after Brexit was “expected and discounted by markets”.

However, Jones said he was surprised by the speed of rating changes made by agencies after the referendum, given nobody knows the likely outcome of negotiation.

“With sterling markedly cheaper, foreign direct investment may even pick up as overseas investors find everything 10% cheaper than last week. So I am not sure why the rating agencies have moved so quickly,” Jones said.

What Do Ratings Downgrades Mean for Bond Investors?

Gartside said the UK’s rating downgrade is unlikely to have an impact on gilt yields, given that expectations for economic growth have been downgraded and the Bank of England is likely to ease policy further this year – yet both of these factors are likely to push gilt yields lower from current levels.

Jim Leaviss, head of retail fixed income at M&G Investments echoes Gartside’s views, saying markets have generally not punished downgrades on highly rated sovereigns. “There is no significant default risk for a nation which can print its own currency,” Leaviss said.

“The ‘losers’ in bond markets are the riskier fixed income assets.  As further EU breakup fears grow, Italian and other peripheral government bonds are underperforming,” he said.

UK investment grade debt offers a remarkable yield compared to what is on offer in Europe, according to Jones. “For this reason I continue to see investors buying UK paper despite the political shenanigans and general Brexit uncertainty,” he said.

UK’s bond yields marked their biggest two-day fall early this week since the Bank of England started its quantitative easing bond buying in March 2009. Demand of gilts has pushed prices high and yields low.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Barclays PLC216.75 GBX0.86Rating
HSBC Holdings PLC697.00 GBX0.07Rating
Santander UK PLC 8.625% PRF UNDATED GBP 1131.00 GBX0.00

About Author

Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk

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