Fixed IncomeMay 8 2014

News Analysis: Getting Europe back on track

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Foreign holdings of Spanish government bonds have soared since early 2012 by more than €70bn (£57.6bn) to €182bn, close to its €188bn peak reached in April 2011, according to Barclays.

Meanwhile, interest in other peripheral eurozone government debt has also surged in the past two years.

Bond yields for Portugal, Ireland, Italy, Greece and Spain, have all fallen recently, with 10-year Spanish bonds dropping below 3.1 per cent last month, while five-year bond yields sunk below those on US Treasuries of the same maturity.

While politicians and central bankers of the peripheral countries have welcomed this as a sign of increasing confidence, not everyone greets it as good news.

Stewart Cowley, Old Mutual investment director, fixed income and macro, says: “Spanish and Italian debt is now caught in an unholy feedback loop; it is not being bought because things are good, it’s being bought because things are so bad.

“The self-inflicted wound of increasing the need for banks to hold government bonds, combined with the need from retail investors for income in an income-less world is pushing investors into peripheral European bonds. Opportunist trend followers are exaggerating the effect. This isn’t so much a race to the bottom, as a race to the positively subterranean.”

Mr Cowley says that while the European Central Bank (ECB) stares deflation in the face, with an ever-shrinking quantity of money in Europe behind it, the markets are doing its work by driving yields and market rates down, while it “sits helplessly on the sidelines.”

Bryn Jones, Rathbones Unit Trust Management’s fixed income specialist also voices concern. “Five-year Spanish government bonds are on a lower yield than UK gilts of the same maturity, even though the UK government is AA rated, while Spanish debt is BBB,” he explains.

“So you can invest in a government bond which has a lower credit quality, but gives you a lower return. That tells me that things are relatively expensive, so we haven’t been buying Spanish government debt recently.”

Rathbones invested in Portuguese and Irish debt in 2011 and recently took profits of 10 per cent and 6 per cent respectively. “Most of the juice has been squeezed out of the Mediterranean fruits,” he claimed.

“All the easy stuff has gone.”

But could the large amount of peripheral debt in foreign ownership be of concern, in the event of another eurozone crisis?

Mr Jones believes it would be more destabilising if the Spanish banks had to buy their own debt and welcomes foreign ownership as a sign of foreign direct investment in the country. Jack Kelly, Standard Life Investments’ investment director for government bonds, bought European peripheral debt roughly nine months ago and has added incrementally since then.

“Foreign ownership is a double-edged sword, in the sense that on paper, potentially, you are more likely to exit if you see more uncertainty in a debt market,” he says.

Put in context, he says, the sources of extreme volatility in peripheral bonds over the acute phases of the crisis, arose against a backdrop of debt restructuring being openly considered as a legitimate policy response (for example, the Deauville Summit), whereas the current environment is quite different, with lessons learned at policymaker level.

The likelihood of debt restructuring rearing its head has dissipated. During the crisis, investors who were taking risk in other assets would have very little tolerance of this kind of volatility in the bond market, which was seen historically as a safe haven.

But is the large amount of foreign ownership putting extra pressure on the ECB to get policy right?

Mr Kelly says: “One of the reasons why we are positive is the likelihood of non-conventional policy in Europe, where the sticking point for QE in the past was that it was seen, particularly by the Germans, as a way of propping up insolvent sovereigns, so it was always avoided and never contemplated in any genuine sense.”

But he thinks the hurdle rate for QE to be undertaken in Europe is high in that the ECB would want to see more evidence of deflation across Europe.

One of his concerns would be a divergence in the inflation path in countries within Europe, although he currently sees no evidence of this, seeing much more harmonisation – a positive for the peripheral debt story.

“The driving factor behind ECB policy action will be the deflation threat. It is now seen as a valid policy response within the central bank’s mandate, with the added benefit of improved borrowing costs for the periphery.

“The ECB will in no way want to stigmatise ownership of peripheral debt, because it would be counterproductive in blocking the transmission mechanism of policy and they will be acutely cognisant of this through the Asset Quality Review and stress tests [later this year].”

“We continue to see peripheral debt outperforming core markets in Europe in this environment. We now have a more stable ownership of the investor base which is less likely to become nervous.”

Mr Jones agrees that, irrespective of foreign or local ownership, the ECB will do some form of QE, but in asset-backed securities and securities that make a difference.

“It will be away from sovereign debt which will be corrected by the outright monetary transactions policy,” he says.

“It is more about keeping the union together, getting the policy right and keeping the economy on the right track.”