Recent turmoil in the UK’s water utility sector has brought home to investors the age-old warning: diversify, diversify, diversify. We find that investing with a global mindset enables much more effective portfolio diversification and far wider opportunities to add value.
Think Outside the Currency Box
We believe that sterling-based bond investors shouldn’t be swayed by home-country and currency bias and should shun unnecessary limitations on their breadth of investment choice.
The recent instance of the largest water utility in the UK—and one of the largest issuers in the sterling market—going into distress was a harsh reminder of how bias toward a single currency can hurt performance. Sticking to a narrow market with limited opportunities makes it hard for investors to avoid shocks in securities that form a large part of the index.
But a global approach has other advantages, too. Over recent decades, companies worldwide have diversified their businesses geographically and increased their exposure to overseas currencies. They’ve also diversified their debt issuance beyond their home currency. This has provided bond investors with the flexibility to implement their investment strategies across a wider range of issuers and currencies (Display). Such an approach can help both to mitigate risks and enhance returns, all while remaining fully currency hedged.
Don’t Fence Yourself In
Consider the limitations of sterling versus global indices. The ICE Bank of America Sterling Investment-Grade Index contains fewer than 1,000 bonds, compared with around 19,000 in the Global Index. Sterling high yield has fewer than 100 issues, representing less than 3% of the global high-yield market. The sterling investment-grade corporate market also grew at a much slower pace than both US dollar and euro peers over the past decade, at only 37% compared with 96% and 110%, respectively.
Limiting a mandate to bonds issued solely in sterling rules out not only many opportunities to add value through security selection but also the potential for more effective diversification. Sterling bond markets are more concentrated than global equivalents: in investment-grade credit, for example, the top three sectors represent 56% of the sterling index but only 40% of the global index, which contains almost seven times as many companies. Issuer concentration is more pronounced in sterling credit too (Display).
Source: Bloomberg and AB
Higher concentration risk means a greater probability of significant loss if a company or sector runs into difficulties. For instance, at the beginning of 2024, the biggest constituent of the UK water utility sector represented around 1% of the sterling credit market—and since the summer has been downgraded by over seven notches from investment grade to deep high yield.
Most UK sterling bond portfolios had at least some exposure to this issuer because of its size in the Sterling Index, and as it fell from investment grade their losses were increased by the lack of liquidity in the sterling high-yield market, which is valued at just £37 billion versus euro and US dollar peers at €384 billion and $1.4 trillion respectively.
Deeper markets with larger buyer bases provide a smoother transition from investment grade to high-yield status; by contrast, the small size of the Sterling Index made it much harder for such a large downgrade to be well absorbed.
Greater Diversity Means Wider Opportunity
Active fixed-income managers aim to add value by taking views on a variety of factors besides individual security selection. These include sector selection, interest-rate risk (duration), credit risk and sensitivity to market changes (beta). With a global mandate, managers have maximum flexibility to implement their views across yield curves, credit ratings and currencies, choosing from the widest possible range of securities to seek improved performance and risk outcomes.
One attraction of the sterling market is that it provides access to long-dated bonds. But that’s not a unique feature, as debt markets in the US—and increasingly the eurozone—also include a large pool of long-dated issues. Hence, mandates based on global markets can offer the same advantages as sterling, and with more flexibility (Display).
Such wide-ranging mandates require effective systems to research and evaluate vast numbers of securities around the world to fully take advantage of the global opportunity set.
It’s a curious anomaly: the UK has one of the more open economies in the developed world, with foreign trade representing 66% of its GDP. Yet many sterling-based fixed-income investors remain anchored solely to sterling-denominated bonds. We think it’s time for them to set sail for wider horizons, in search of better risk-adjusted returns.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.
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