EuropeNov 16 2017

The outlook for European fixed income

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The outlook for European fixed income

The central bank has been lagging its UK and US counterparts in terms of monetary policy for many years but looks to be on a similar path now, following improving economic data from the region.

ECB president Mario Draghi announced at its October meeting that following years of monetary stimulus, during which billions of euros were pumped in by the central bank, it was beginning to taper – albeit slowly.

From January 2018, the ECB’s bond-buying programme will be scaled back from €60bn a month to €30bn a month.

This marks the beginning of the end of unconventional monetary policy in Europe, although Mr Draghi has been clear of the need to reinvest the proceeds of its bond purchases for as long as necessary.

With the ECB’s policy extended well into 2018, the technical support for at least the European bond market remains in place.Kommer van Trigt

Unlike the UK and US, however, Mr Draghi has not begun raising interest rates and could still be some years away from doing so.

Slow and steady

What has prompted this very cautious change in direction from the ECB?

Rogier Quirijns, senior vice president and portfolio manager at Cohen & Steers notes: “After years of sluggish growth, Europe’s prospects have brightened considerably amid rising consumer and business confidence, a healthy job market, continued low inflation and a marked improvement in the region’s political climate.”

Chris Iggo, chief investment officer, fixed income at Axa Investment Managers, says: “Looking at the ECB it is still a net buyer, having taken modest steps towards exiting quantitative easing (QE) by announcing that it would reduce its monthly asset purchases to €30bn per month from January and would look to terminate the buying programme in September 2018. 

“This was in line with market expectations, on the whole, and was sugar-coated by relatively dovish comments from President Draghi.”

He believes the ECB’s motivation for continuing to be accommodating is easy to understand.

“Inflation is running at just 1.5 per cent in the euro area, the recovery is still in its infancy relative to other parts of the world, and there are political risks to the stability of parts of the sovereign debt markets,” he reasons. 

“Rate hikes in Europe are also distant which will allow the yield curve to remain relatively steep (117 basis points between German 10-year and two-year bonds) and this is good for banks and the broader economy.”

Mr Iggo points out: “The importance of the ECB’s ongoing buying is no better illustrated than by the fact the spread between Spanish government bonds and German bonds has been pretty stable despite the ongoing situation in Catalonia.

“If the ECB wasn’t buying or had announced a more rapid winding down of its QE programme, I suspect that Spanish spreads would be much higher today than they are.”

Where next?

Fixed income investors may be wondering where yield curves can be expected to go now that the ECB has confirmed the trajectory of monetary policy.

Kommer van Trigt, head of global fixed income macro at Robeco, forecasts: “We expect this combination of gradual tightening and modest inflation to lead to a flattening of yield curves, tightening of euro periphery spreads and a compression of the spread between US Treasuries and Bunds. The investment grade credit market continues to perform well. 

“With the ECB’s policy extended well into 2018, the technical support for at least the European bond market remains in place.”

Fears among advisers and their clients that the bond bull market run is over seem to be unfounded, for now.

But investors allocating to European fixed income need to bear in mind the economic and fiscal backdrop as they are doing so.

David Stubbs, head of client investment strategy for EMEA at JP Morgan Private Bank, suggests a fixed income allocation that benefits from Europe’s economic growth revival, increase in financial lending and accommodative central bank monetary policies is a compelling option for investors. 

“Yet current yields suggest traditional fixed income investments do not offer the risk-reward trade-off they did in the past, and there is a requirement to consider other ideas,” he points out.

“One of the opportunities we have identified outside of the core eurozone involves investing in fixed income securities denominated in Turkish lira."

Double-digit yields are available on short maturities of only a couple of years, with bonds issued by supranational agencies of particular interest, Mr Stubbs explains. 

“Naturally such an investment involves exchange rate risk. However, while it is far from certain that the Turkish lira will strengthen materially, the era of rapid depreciation appears to have ended.”

Currency hedging is a strategy also proposed by Brewin Dolphin’s head of research Guy Foster.

In particular, short duration credit strategies, with a focus on high yield and emerging market debt, remain an attractive choice for fixed income investors.Chris Iggo

“Bond yields are clearly very low in Europe and while we found the single currency compelling earlier in the year we now feel the value has eroded. 

“Enhancing yields through currency hedging is therefore attractive, particularly after the recent UK interest rate rise but duration risk remains elevated and poorly compensated,” he comments.

Shake it off

For Mr Iggo, the fixed income environment in Europe is conducive to generally positive returns.

“Even with rates, the likely increases are going to be modest in the short-term given the ongoing, albeit smaller, expansion of central bank balance sheets at the global level.”

He acknowledges: “Positive yield curves do offer some protection against monetary tightening, while strong fundamentals support exposure to credit markets. 

“In particular, short duration credit strategies, with a focus on high yield and emerging market debt, remain an attractive choice for fixed income investors as they tend to derive returns from income and tend to limit drawdowns when volatility picks up.”

While bond markets have seemingly been able to shake off any concerns over the political situation in Catalonia, he says there are other risks they may react more strongly to, such as Brexit.

David Zahn, head of European fixed income at the Franklin Templeton Fixed Income Group, confirms: “While we don’t believe the disagreements in Spain are likely to have a major impact on financial markets, other political uncertainty such as Brexit negotiations continue to make little progress and if talks break down, we would expect gilt yields to be significantly lower and get close to lows again.

“Europe never seems to have a dull moment and, over the next 12 to 18 months, we believe this continued volatility will present opportunities for managers to capture opportunistic pockets of yield.” 

eleanor.duncan@ft.com