All eyes are on what will happen next in the European government bond market, following European Central Bank (ECB) chief Mario Draghi’s hint that monetary easing might be considered in the future.
As such a move could involve buying government bonds to push down their yields, how are fund managers positioning their exposure to European sovereign debt? Stuart Edwards, a fixed interest fund manager at Invesco Perpetual, attributes current low yields on German government bonds, known as bunds, and other European government bonds to low inflation and the ECB’s bias towards easing.
“ECB support will stay in place for some time, so we are likely to remain in a generally low-yield environment,” he says. “That said, the European government bond market rally has come a long way and possibly too far. As a result, I have scaled back my exposure, by hedging interest rate risk.”
Edward Smith, Canaccord Genuity Wealth Management’s global strategist, says he does not advocate positioning into the periphery. Gabriela Schneider, Aviva Investors’ global markets fund manager, says within a global bond portfolio context, the company’s positioning in duration terms is neutral, as the market has already priced in the ECB’s recent measures.
Nathan Sweeney, Architas’s senior investment manager, says yield differentials between European core and peripheral bonds have declined substantially from their highs in the past two years, and thus look less attractive. “Could yields grind tighter? Yes, if you consider that core and peripheral bonds were very correlated and traded tightly pre-credit crisis,” he explains.
“However, given that recent data points suggest deterioration in parts of peripheral Europe, it is not outlandish to expect peripherals to have a higher risk premium.”
David Tan, global head of rates at JPMorgan Asset Management, believes European government bonds will remain supported by continued low, but positive growth and inflation in the next two years, along with a highly accommodative central bank. While he expects core government bond yields to normalise as the eurozone economy continues to heal, the move will be gradual and not very different to what is already priced into the forwards market, making shorting them a tricky proposition.
“In terms of exposure to peripheral bonds, we recognise that major compression in spreads has already occurred and lightened up a little,” Mr Tan says. “Yet we remain overweight peripherals due to the genuine progress that these countries have made in terms of structural reforms and stabilising public sector debt.”
So what will the drivers of any ongoing rally be or are European government bonds set for a sell-off?
Mr Edwards says: “The US Treasury market is a key driver of interest rate sentiment globally. US growth is picking up and the Federal Reserve is exiting its quantitative easing programme as a precursor to interest rate rises. This will put upward pressure on US bond yields and, by extension, European yields. European bonds will likely outperform US bonds, but prices could still fall in the event of a sell-off in the US Treasury market.”
Mr Smith says the sovereign banking nexus has still not been broken and this could lead to renewed volatility as the results of the Asset Quality Review (AQR) are published later this year. He questions how much the Spanish economy has properly adjusted, saying that if the AQR reveals capital shortfalls, the concerning feedback loop between banks and sovereign bond yields may become apparent again.
“We do not envisage a crisis anew, but investors may realise that there is still a little more systemic risk in eurozone debt than they are currently pricing for,” he says.
Ms Schneider believes yield levels will remain depressed in Europe for the foreseeable future and the chances of a large sell-off are unlikely at this stage, particularly given expectations of QE.
Mr Sweeney says the easy money has been made and that now there will be more focus on data, as a result of the ECB’s recent action. He believes spreads may trade tighter over the medium to long term, but expects more volatility in the short term, as data points confirm the success or otherwise of the recent announcements.
So how should investors be allocating to European government bonds and is there a concern about the rapid fall in yields, particularly in the periphery? Mr Edwards says that this plunge in yields reflects important improvements and that the sort of tail risks associated with peripheral bonds in 2011/12, related to a possible break-up of the currency union and systemic problems in the banking system, have now diminished.
“There has also been an improvement in the fundamentals,” he says. “Growth is picking up – albeit from a low base – and structural reforms are being implemented.”
Ms Schneider believes the hunt for yield will remain a key driving factor. He expects periphery spreads to remain well supported and has positioned accordingly. “Some volatility is likely, however, as the market attempts to gauge the extent, nature and timing of the next ECB steps,” she says.
Mr Tan says the pace of compression will be more gradual and less monotonic going forward and has shifted most of his overweight positions to the shorter end of these markets, where the ECB will continue to provide indirect support.
He explains: “The new targeted LTROs [low cost loans to businesses] also provide evidence that ECB monetary policy will remain loose for the next few years, and this is very positive for shorter-dated peripheral bonds around the three to five-year maturities.”
Mario’s move
The European central banker had been under great pressure to implement some form of stimulative policy to prevent the bloc entering a deflationary cycle and has now obliged.
Mr Draghi has moved the central bank’s deposit rate into negative territory, which means commercial banks are being charged to put their cash with the ECB. This is, therefore, supposed to stimulate lending.
The ECB has also implemented a low-cost loan programme, so banks can borrow money for low rates secured against assets on their balance sheets. Again, this could be stimulative for the economy, but supply of credit will need to be met by demand, and some question whether this is prominent now or will be for years to come.
