Searching for Yield in UK Bonds

The Federal Reserve may be raising rates, but UK and Europe interest rates remain low, says BlackRock's Ben Edwards

Emma Wall 20 September, 2018 | 7:26AM
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Emma Wall: Hello, and welcome to the Morningstar series, "Why Should I Invest With You?" I'm Emma Wall and I'm joined today by Ben Edwards, manager of the BlackRock Corporate Bond Fund.

Hello.

Ben Edwards: Hi.

Wall: So, interest rates are rising, or indeed, central banks are raising interest rates. How is that impacting corporate bond yields?

Edwards: Well, it is. The spectre of high rates has been something that we've been dealing with for a few years now. What I would say is that what's happening in the U.S. is slightly different from what's happening elsewhere, particularly in Europe and particularly in the U.K. Obviously, we've seen a rate rise recently from the Bank of England. But our feeling all the way through really was it was unlikely that Europe and the U.K. would be able to match where the U.S. and where the Fed has got to recently.

So, one very important part of fixed income markets is that very attractive yield is on offer. Now, from a risk-free asset in the U.S. really isn't the same thing that we're seeing here. We still have negative deposit rates in Europe. We still have very low interest rates in the U.K. And obviously, that affects corporate bonds because it allows yields to stay relatively low, it allows corporate bonds who have a higher yield than that to remain relatively attractive.

Wall: I think the first part of that answer was very interesting in so far, as you said, this is not a surprise phenomenon. We have known that this market would be coming for some time. Does that help you as a bond fund manager prepare for what is going to come in the future?

Edwards: Absolutely. I mean, the fact is that interest rates, particularly in the U.S., were leading this part of the cycle. They were going to be starting this cycle in 2015-2016. In fact, what we had was a nice 18-month period really where this cycle has been deferred to a very large extent.

We find ourselves back there now. But because of that the time value of those bonds actually means that we are now dealing with bonds that have generated value, they've generated income while we were waiting for interest rates to go up and that does allow us as fund managers to position portfolios at certain parts of the yield curve that have become more attractive, certain parts of the U.K. yield curve, for instance, where we have a powerful roll-down effect that generates capital returns even though rates might be going up one day.

Wall: And you said that rates do remain low in the U.K. and indeed, in Europe, both in terms of sort of central bank rates but also corporate bond rates. Where then are you seeing value, because of course low yields means high prices?

Edwards: Yeah. So, it's fair to say that government bond yields still are very low. They don't offer a lot of value to us as investors. They certainly don't offer a lot of appetising yields to our sort of clients.

But corporate bond yields have actually become more attractive since about January-February time when we started dealing with, I think, a trickier volatility environment in fixed income and actually, in all asset classes. So, we've seen spreads widen above governments', particularly in Europe. We've seen spreads widen in the U.K.

That means we are getting more income for good-quality companies. Some of the tactical opportunities we are seeing also means that a market that was really no use to us at all in terms of continental Europe, the yields there were very low, the spreads there were very low, largely to do with ECB bond buying.

Now, suddenly, on a swap basis once we take out the FX risk, suddenly those are starting to look attractive in absolute terms in investment-grade companies that can yield us 4%, 5%. That's starting to look good to our investors relative to what we can buy in the U.K., particularly what we can buy in the U.S. on a swap back basis.

Wall: And what about any particular sectors? Because equities, there has been quite a lot of divergence sector-by-sector. There are some sectors that look very expensive, but there's also some that look good value. Can the same be said in the fixed income market?

Edwards: Well, we've spent seven years basically with central banks trying to make us ignore the fundamental quality of different sectors or the direction of travel for those credits and actually, we got to that tipping point it feels like in January-February time. Actually, now, we've seen a much more diverse range of opportunities.

So, we are looking at particularly where we think we are in the cycle, which is, towards the end, it'd be brave to call the end, and many have tried. But we are towards the end, not towards the beginning. That leads us to want to think about companies with safe cash flows, asset-backed securities, utility companies, rather than those that are leveraged to further growth in the economy.

Wall: Ben, thank you very much.      

Edwards: Pleasure.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar