The rush for cash from UK pension funds has weakened the already fragile market for sterling-denominated corporate debt and is driving up borrowing costs for businesses across the country.
UK government bonds fell sharply last month as investors backed off on Chancellor Kwasi Kwarteng’s plans for unfunded tax cuts as debt remained under pressure in early October. Pension funds were forced to sell more gilts to maintain their hedged positions, forming a spiral that the Bank of England stepped in to stem.
But pension schemes also offloaded sterling corporate debt during this volatile episode. Fund managers say it hit assets including bonds for companies such as Virgin Media and Rolls-Royce.
“What you see in the corporate bond market is a sellout,” said Paola Binns, portfolio manager of sterling corporate bonds at Royal London Asset Management.
This means investors are demanding a higher yield to hold UK corporate debt. “You had that before, with Brexit – UK borrowers had to pay a premium to access the corporate bond markets. It’s coming back now,” Binns said. “The government will say that interest rates are rising everywhere, but they are rising much more aggressively in the UK than anywhere else.”
To ease the pressure, the BoE boosted its support for pension schemes on Monday by expanding the range of collateral that can be pledged under its new short-term funding facility. Among the assets that will be accepted are UK corporate bonds.
“This should reduce the number of forced sales in these markets and thus reduce contagion,” said Antoine Bouvet, rates strategist at ING.
By extending the type of collateral to some sterling corporate bonds, the measure could support pension schemes that still need cash, which would have a “pleasant trickle-down effect”, said portfolio manager Simon Matthews. senior at Neuberger Berman.
Binns added that prices of sterling-denominated bonds improved at the open on Monday, but it was unclear how the measure would play out. By Friday’s close, the average yield on an Ice Data Services index of high-quality, sterling-denominated corporate bonds had risen to 6.7%, from 5.6% before the “mini” budget.
Supermarket group Iceland, restaurateur Boparan and Bracken, owner of specialist mortgage lender Together, are among companies whose already high debt yields have soared since the “mini” budget. Icelandic bonds maturing in 2025 are now trading with a yield of 16.8%, compared to 15.8% before Kwarteng’s speech on September 23. Yields rise when prices fall.
The yield on a sterling-denominated Rolls-Royce bond maturing in 2026 jumped 2 percentage points after the “mini” budget to over 10%, and remained higher. Debt in dollars held up better; a Rolls-Royce dollar bond is trading at a similar level to before Kwarteng’s intervention.
Going forward, international companies like engineering firm Rolls-Royce could seek to fill funding gaps by borrowing from other markets, Matthews said, further weakening trading in the sterling market. .
The UK corporate debt market is already small compared to Europe, and few banks have dedicated sterling trading desks, making it a difficult market for investors to navigate. Some had reduced their exposure long before the government released its new budget plans.
“Many investors have turned their backs on the sterling market,” said Tatjana Greil Castro, co-head of public markets at Muzinich & Co, a fixed-income asset manager. “Our exposure is naturally decreasing and we are happy to bring it down to zero.”
The lack of demand means it “only trades by appointment in large stretches of high-yielding sterling,” Matthews said. “[Demand] bordering on pathetic. It was bad before the budget, but it made it worse.
This will increase borrowing costs and hit mid-cap companies that do much of their business in the UK harder than international companies, which may seek funding in euros or dollars, investors say. “It’s a real problem for companies whose revenues are in pounds sterling and who cannot come to market in euros and dollars,” added Greil Castro.
One consolation is that few companies have immediate borrowing needs, having secured capital in recent years when interest rates were low. This gives the UK economy time to grow before many companies seek to refinance their debt.
But the prospect of a longer and more protracted recession in the UK than elsewhere in Europe will likely mean investors will continue to demand higher yields, hurting business investment and Prime Minister Liz Truss’ plans to expand. the UK economy, Binns said.
“For businesses, your margins are tightening while your borrowing costs are rising. So any cash you have, you’re just going to hold it and manage it more efficiently. You’re not going to grow your business,” she added.
Additional reporting by Robert Smith