Inflation in the UK has clearly been on an improving trend throughout 2023. At the time of writing the most recent figures from the Office for National Statistics (ONS) are from November, at which point the UK’s rate of Consumer Price Inflation (CPI) was 3.9%, significantly down from the 10.1% figure from January 2023. 1

So, is the UK out of the woods when it comes to inflationary worries? I would argue not. Annual growth in regular pay (excluding bonuses) for UK workers is currently at one of the highest levels since comparable records began in 2001, according to the ONS. What is more, at 7.3%, pay growth is exerting upward pressure on the headline level of CPI. 2 Whilst the near-term outlook looks promising for the path of inflation, markets are failing to recognise the risk that inflation may start to tick up again unless we see a material change in labour market conditions.
What makes the UK different?

There are other factors, idiosyncratic to the UK and not present for its developed market peers, that in my view will also conspire to slow the rate of disinflation. The way the UK’s energy market is regulated means that energy costs remained higher for longer than in many other markets resulting in a longer period of sustained upward pressure on inflation. At the same time, the size of the UK’s workforce has been slower to recover from the dip seen during the pandemic. The corresponding lack of workers in the UK is helping to drive pay growth.

 

Furthermore, the UK had more strikes in 2023 than any other year since the 1980s. Despite some deals being struck, many workers have still seen their pay fall in real terms compared to before the pandemic. Unions may therefore be encouraged by success achieved so far and continue to ask for more pay, even with inflation dropping. There’s also the election factor. With a general election widely expected to take place sometime in 2024, there will be an incentive for the government to increase spending which may ultimately result in further upward pressure on inflation. This may lead to elevated risk of another interest rate rise or at least require the Bank of England to maintain rates at high levels for longer. The sterling investment grade credit curve has steepened into the poll date in every one of the last 3 election cycles in the UK, suggesting that shorter duration positioning may be appropriate.

 

The interest rate question is a critical one for fixed income investors. Views across the market clearly will differ, but my own take is that the Bank of England may fail to deliver the level of interest rate cuts that bond markets are pricing in for 2024 without a very big rise in the unemployment rate and at the same time a slowdown of pay growth. While those outcomes are possible in theory, neither would be my base case for what transpires in 2024.

Companies with robust balance sheets can absorb higher rates

With interest rates at such elevated levels, company CFOs have not been eager to refinance their existing bonds – naturally, firms do not want to pay higher rates – but as maturity dates loom, companies will be forced to refinance. When they do so, I would anticipate the average coupon (i.e. the cost of debt for issuers) to rise and this will have adverse effects for issuers.

 

The investment grade market has a relatively long duration, and the impact of interest rate changes has so far been slow. Interest coverage across the whole investment grade universe is more than 10x, and so companies should be able to handle the higher cost of debt easily. However, this cost will still need some adjustment elsewhere on the balance sheet, for example by raising prices, cutting costs, reducing capex or lowering dividends.

 

The high yield market has a much shorter duration and so the rising cost of debt for those companies will be felt more swiftly. Yet even here, average interest coverage of around 6x means that many issuers can refinance at much higher rates without putting themselves in to much difficulty. Weaker issuers are likely to face challenges, though, and I am seeing more variation in the lower-rated segments of the market.

Will high yield crash into a maturity wall?

The lack of eagerness of CFOs to tap the market in 2023 has resulted in a noticeable reduction in duration of the high yield bond market as a whole. To the extent, in fact, that worries have grown of a ‘maturity wall’ in 2025/2026 when a high level of refinancing may need to occur. A surge in activity in the primary markets near the end of 2023 has gone some way to easing these concerns, however. High yield issuers who have tapped the market in recent months have generally seen their coupons more than double, but at least they have still been able to get their deals away.

In case you might conclude that talk of a maturity wall is a lot of fuss about nothing, then think again. When one examines the cash flow potential of the credits in the market today, it is evident that some of the more levered structures would have trouble supporting a doubling in the cost of debt – these are the sorts of credits that active investors are able to avoid. Indeed, careful examination of market dynamics and astute active stock picking seem essential in this current environment, in my view.

 

As usual, the key is in the detail. Companies do have levers they can pull; for example, stopping returns of capital to shareholders or slashing capex, although this may leave little wiggle room in an environment of slower growth. Another strategy that has become popular in the current high interest rate environment is the use of “Amend and Extend”. This tactic is usually used when companies think that investor demand would be insufficient to achieve a normal bond refinancing, but when the situation is not seen to be bad enough to require a full restructuring. Bond holders are typically offered attractive terms to extend their debt maturities. These solutions are usually based on the implicit assumption on both sides that the rate environment will improve and that a full refinancing will be done at market terms and at lower rates. Pushing the problem further into the future in this way is risky, in my view.

Finding the sweet spot in 2024’s credit markets

My expectation for 2024 is that it will offer a great chance for fixed income investors to benefit from the high yields that the asset class currently offers and, with yield break-evens close to 10-year peaks, this means that the asset class may be able to withstand any downside risk relatively well. This is especially the case for short-dated high yield, where good credit research teams who can tell the difference between companies that can refinance easily and those that might have difficulties, can add value.

If big rate cuts were to occur, then longer duration investment grade should be well positioned to perform, while a more persistent inflation scenario brings downside risks to this part of the credit spectrum. For investors able to balance the two, a mix of investment grade and high yield – backed up by smart security selection – may represent a sweet spot for attractive returns at a moderate level of credit risk in 2024.

1 Consumer price inflation, UK – Office for National Statistics
2 Average weekly earnings in Great Britain – Office for National Statistics (ons.gov.uk)

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