UK and US banks' Short-term Investment-grade bonds: Appealing yields, defensive in nature

Central banks are gradually lowing interest rates, signaling the end of the era of high deposit rates
UK and US banks' short-term investment-grade bonds offer attractive and stable returns, with relatively lower risk
While interest rate cuts may compress banks' net interest margins, other fee income is expected to rise, so the overall impact on profits is believed to be limited

Short-term investment-grade bonds: Relatively low credit risks, highly defensive

The stage is set for rate cuts, and it's about time to bid farewell to high-rate savings. For those seeking attractive and stable income without taking on excessive risks, BEA Union Investment sees allure in short-term Investment-grade bonds issued by UK and US banks.

The Bank of England lowered interest rates for the first time in August, with the US central bank likely to follow suit this month. Cutting interest rates could shore up the economy and encourage borrowing, although it will take time for meaningful effects to materialise. Nonetheless, the banking industry should eventually benefit from a more accommodative monetary policy. Both the UK and US have robust economies and financial systems. Investment-grade bank bonds in both markets have an average credit rating of A- and offer appealing yields of 5-6%. In addition, short-term bonds have shorter maturities, meaning operations of banks and macroeconomic conditions are less likely to deteriorate in a short period. This allows credit rating agencies and investors to more accurately evaluate the issuer's financial health.

The disinflationary trend remains intact in both the UK and US, while job markets are holding up reasonably well. Although the US saw fewer non-farm payroll additions than anticipated in August, the jobless rate edged down to 4.2%. The UK unemployment rate eased to 4.2% in June, down from the peak of 4.4%. The UK experienced economic growth for two consecutive quarters, with the International Monetary Fund lifting its UK GDP forecast this year to 0.7% from 0.5%. Growth in the US economy is even more prominent, with second-quarter GDP rising 3.1%. Improving solid macro conditions support the repayment capacity of consumers and companies, subsequently strengthening the quality of bank assets. In any case, banks have been prudent in extending loans since the financial crisis. Major US banks reported relatively flat or slightly declining outstanding loan volumes in the second quarter. Fitch Ratings noted that US lenders are adopting a conservative stance towards capital and liquidity management in anticipation of tighter regulatory requirements.

Rate cuts have relatively minor effects on profitability of UK and US banks

Lowering interest rates might compress banks' net interest margins (NIMs), but the overall impact on their earnings should be limited. Declining rates could buoy market sentiment, potentially spurring merger and acquisition activities, as well as trading in equities and bonds. This could bolster fee-based income for banks, helping to counterbalance the drop in NIMs, and support earnings. This trend is already evident in the second-quarter results of British and American financial institutions. Furthermore, their earnings remain stable, and leverage ratios are not elevated, with some banks even announcing share buybacks, underscoring robust financial health.

Since the rate-cut cycle remains in its early stages, the interest rate environment is still considerably high. Some UK banks are using this window of opportunities to manage interest rate risks and mitigate pressure on their NIMs through structural hedges. A major UK bank expects that income derived from structural hedges will increase by GBP2 billion by 2026 from 2023. As existing hedges expire, the lender could enter into new contracts with higher yields. According to S&P Global Ratings, higher yields on UK banks' structural hedges will be increasingly apparent starting from the second half, helping to shore up balance sheets.

With rates still staying relatively elevated, short-term bond yields remain reasonably high. Before the US joins the rate-cut bandwagon, investors can still take advantage of the attractive yields offered by short-term bonds. Given the low risk of mark-to-market fluctuations, consider locking in the decent yields while they last. Once market visibility improves, one can always rebalance the portfolio as needed.