Pension fund strike for cash shakes UK corporate debt

A rush for cash by UK pension funds has weakened the already shaky sterling corporate bond market and pushed up borrowing costs for companies across the country.

UK government bonds fell sharply last month as investors balked at Chancellor Kwasi Kwarteng’s plans for unfunded tax cuts, with debt remaining under pressure in early October. Pension funds were forced to sell more gilts to maintain their hedged positions, leading to a spiral that the Bank of England wanted to stop.

But pension funds have also dumped corporate debt in sterling during this volatile period. Fund managers say this has hurt assets, including bonds for companies like Virgin Media and Rolls-Royce.

“What you’re seeing in the corporate bond market is a sell-off,” said Paola Binns, sterling corporate bond portfolio manager at Royal London Asset Management.

This means that investors are demanding a higher yield for holding bonds from UK companies. “You’ve had it before with Brexit – UK borrowers had to pay a premium to access corporate bond markets. It’s coming back now,” Binns said. “Government will say interest rates are going up everywhere, but they’re going up much more aggressively in the UK than anywhere else.”

To ease the pressure, the BoE increased its support for pension schemes on Monday by expanding the range of collateral that could be pledged under its new short-term funding facility. Assets accepted include UK corporate bonds.

“This should reduce the number of forced sales in these markets, thus reducing contagion,” said Antoine Bouvet, rates strategist at ING.

Sterling Corporate Index line chart (return, %), showing the rise in the cost of borrowing for UK companies

By expanding the type of collateral to some sterling corporate bonds, the measure could support pension schemes that still need cash, which would have a “nice trickle-down effect,” said Simon Matthews, senior portfolio manager at Neuberger Berman.

Binns added that sterling-denominated bond prices improved at Monday’s open but it was unclear how the move would play out. As of Friday’s close, the average return on an Ice Data Services index of sterling-denominated high-quality corporate bonds had risen to 6.7% from 5.6% before the “mini” budget.

Supermarket group Iceland, restaurant owner Boparan and Bracken, owner of specialist mortgage provider Together, are among the companies whose already high debt yields have skyrocketed since the “mini” budget. Iceland’s bonds, which mature in 2025, are now trading at a yield of 16.8 percent, up from 15.8 percent before Kwarteng’s September 23 speech. Yields rise when prices fall.

The yield on a sterling-denominated Rolls-Royce bond due 2026 rose 2 percentage points to over 10 per cent after the ‘mini’ budget and has remained higher. Dollar debt has performed better; a Rolls-Royce dollar bond is trading at levels similar to those before Kwarteng’s intervention.

In the future, international companies like engineering firm Rolls-Royce could try to fill funding gaps by borrowing in other markets, Matthews said, which would further weaken trading in the sterling market.

The UK corporate bond market is already small compared to Europe and few banks have dedicated sterling trading desks, making it difficult for investors to navigate the market. Some had scaled back their exposure well before the government released their new financial plans.

“Many investors have turned their backs on sterling,” said Tatjana Greil Castro, co-head of public markets at Muzinich & Co, a fixed income wealth manager. “Of course, our commitment is dwindling and we’re happy to be able to bring it down to zero.”

Lack of demand means it’s “only trading by agreement with huge swathes of high-yielding sterling,” Matthews said. “[Demand] borders on pathetic. It was bad before the budget, but that made it worse.”

This will drive up borrowing costs and hit mid-cap companies, which do most of their business in the UK, harder than international companies that can seek financing in euro- or dollar-denominated debt, investors say. “It’s a real problem for sterling-denominated companies that can’t market in euros and dollars,” added Greil Castro.

One consolation is that few companies have immediate borrowing needs after raising capital at low interest rates in recent years. That gives the UK economy time to grow before many companies attempt to refinance debt.

But the prospect of a longer and more protracted recession in the UK than elsewhere in Europe is likely to keep investors demanding higher yields, which will hurt business investment and Prime Minister Liz Truss’ plans to boost the UK economy, Binns said.

“For companies, your margins are being squeezed while your borrowing costs are rising. So you will hold back any liquidity you have and manage it more efficiently. You’re not going to expand your business,” she added.

Additional reporting by Robert Smith Pension fund strike for cash shakes UK corporate debt

Adam Bradshaw

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