UK AAA-rating at risk: how bond markets are reacting

The UK is set to lose its prized triple-A credit rating, following the outcome of EU referendum vote, in which the British public has voted to leave the European Union.

While the full repercussions of Brexit are yet unknown, the political, economic and financial risks anticipated to play out in the wake of Brexit are likely to lead to a credit downgrade in the near future.

On Friday, rating agency S&P confirmed that the UK is likely to lose its AAA credit rating.

Moritz Kraemer, chief ratings officer for S&P, told the Financial Times: 'We think that a AAA-rating is untenable under the circumstances.'

Fitch and Moodys, other rating agencies, have already stripped Britain of its AAA rating before the referendum campaign began.

IS A RECESSION IMMINENT?

Despite the announcement that the UK is likely to be stripped of its top-notch rating, gilts have benefited from the panicked risk aversion of investors who fear that a UK recession is imminent.

The benchmark 10-year UK government bond yield fell from 1.3 per cent before the market opened to nearly 1 per cent. But at 11.45am the yield had edged back up to 1.1 per cent.

The US 10-year Treasury yield has also fallen overnight, and the 10-year German Bund has moved sharply back below zero.

All eyes are now on the Bank of England, which has committed to keep the banking sector awash with liquidity.

Jim Leaviss, head of retail fixed income at M&G Investments, comments on the bond market reaction: 'I wouldn't rule out a rate cut from the Bank of England later this morning, perhaps to 0 per cent from 0.5 per cent (although this would likely trigger a further sell off in sterling).'

He adds that markets have generally not punished downgrades on highly rated sovereigns, for example the US when it lost its AAA rating. There is no significant default risk for a nation which can print its own currency.

The losers in bond markets are the riskier fixed income assets, according to Leaviss. As further EU breakup fears grow, Italian and other peripheral government bonds will be sold by nervous investors.

Italian and Spanish 10-year bond yields have risen by 30 basis points (bps) so far this morning. Both yield around 1.5 per cent.

PRESSURE ON EUROPEAN SHARES

Financial strategists at BlackRock predict further pressure on European shares, credit and peripheral bonds, such as Italian government debt. The strategists note this is 'due to likely European job losses and lower growth'.

BlackRock adds: 'We expect limited pressure on government budgets, however, as high-quality government bonds are in demand in a low-rate world.'

Leaviss adds that banks in general, even in 'core' nations, are also performing poorly relative to traditional corporate bonds.

'Corporate bonds are anything from 2 to 8 bps wider. There has been talk of institutional buying at these lower levels, although we are sceptical that there has been much trading so far today,' said Leaviss.

'Credit markets were already discounting a much higher level of defaults than we believed likely and today's moves increase the over-compensation for default risk.

'However, liquidity [is] likely to be low today and potentially for some days to come as the implications of yesterday's vote become clearer,' adds Leaviss.

He says for these reasons the chance to pick up bargains might be limited, so a recession cannot be ruled out.

Bryn Jones, head of fixed Income at Rathbones, expects further volatility in bond markets. He added he is 'waiting for the market to settle and will assess the situation accordingly'.

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