Bonds await fallout from QE and Greek crisis

The European Central Bank’s €60bn a month bond-buying programme, which began in March, has forced eurozone bond yields to levels where there is little value or potential for capital gain. According to Bank of America Merrill Lynch, €1.8tn of European government debt now yields less than zero, in what has been dubbed the fastest-growing ‘new asset class’.

Long term, the question is whether the European quantative easing programme can achieve similar results to the US, spurring growth and inflation into positive territory, but there are significant differences between the American and continental backdrops. 

“In the US, the premise of QE worked well as business and household balance sheets were over-leveraged, allowing for a private-to-public risk transfer,” says Dominick Dealto, head of global multi-sector fixed income at Fischer, Francis, Trees & Watts, BNP Paribas IP’s fixed income manager. “The US Federal Reserve purchased government debt, supported struggling too-big-to-fail businesses and invested large sums in agency mortgages.” 

The eurozone consumer is less leveraged which is a positive, but the public sector, excluding Germany, is overextended, he believes. Euro depreciation should make European goods more attractive to foreign investment which should ultimately spur demand, employment and deleveraging. But there are important cultural differences which cannot be  ignored.  

“The US consumer historically has not been a good saver, whereas the European consumer has,” explains Mr Dealto. “While lower rates in the US, either for the purpose of refinancing more expensive debt or for the purpose of driving investors into higher yielding assets, worked well, it may take longer and more than the ECB has committed to turn the economy around.”

Shorter-term, there is confidence the strategy will work. “We are sceptical of success in the medium term but believe we will see more success in the short term, as inflation has already risen and surprised on the upside and there might be more surprises to come,” says Gerald Goedel, manager of the €424.7m Deka-Lux Bond A fund. He believes the euro and the basing of the oil price might hold back inflation and that growth momentum may also be stronger than expected.

“We are dollar bulls, and are trying to express this in the fund by sizeable long positions against the euro and other currencies,” says Mr Goedel. “We are now in a phase we describe as a currency war, which may sound dramatic, but several countries are trying to weaken their currencies and this activity will gain in importance this year because many central banks can no longer use rates to do so as they are already at their lowest boundary.  The prime example that this policy works is the way the euro has depreciated against the dollar and pound.”

Curiously, however, ECB chief Mario Draghi has applied a larger dose of QE than was generally expected, despite the economy already improving of its own volition. James Knowles, investment director and head of fixed interest at Psigma, wonders whether this hints at the market underestimating the chances of Greece falling out of the system. QE has sheltered other bond markets from any contagion from Greek issues to date as yields have continued to fall to almost unbelievably low levels. 

Recent political posturing has done nothing to ameliorate the stalemate. German finance minister Frank-Walter Steinmeier  and Dutch finance minister Jeroen Dijsselbloem have been open in their frustration that the newly elected Greek government has yet to reach agreement with the nation’s creditors and may choose to put its domestic obligations first. Greece owes €9.7bn to the IMF this year, and its three-year borrowing costs have now risen to 23 per cent, a level at which there is genuine concern that it will not be able to pay its debts.

“The potential Greek crisis is still looming but we believe the Greek risk is idiosyncratic not systemic, because the ECB and other firewalling like the ESM (European Stability Mechanism) should be powerful enough to buffer the rest of the eurozone from a Greece departure,” says Ludo Geris, portfolio manager, fixed income at KBC. 

The restructuring of Spain, Portugal and Ireland show these programmes were quite effective but the Greek problem is in the execution, he explains. “It has targets for 2014 that it has not met. One was a budget surplus of 1.5 per cent of GDP but it is 0.3 per cent, well below target, and the commitment of the new government is unclear. It is a highly political game, but the outflows from Greek banks show time is running out.”

Meanwhile, QE depends on ample bond supply to be workable in practice and as banks, pension funds and insurance companies hold large amounts of government bonds for regulatory reasons, sellers will be thin on the ground. One third of German bunds for instance are held by foreign central banks, according to research by Deutsche AM, further reducing the pool for central bank purchase. 

Some 70 per cent of eurozone government debt is held by domestic investors, mostly banks that have no strong incentive to sell to the ECB because under Basel III they need to hold onto bonds, says Franck Dixmier, CIO of fixed income Europe at Allianz Global Investors. “Insurance companies and pension funds own 22 per cent and what matters for them is the level of the yield when they purchased the bonds; there is no incentive to give them up and reinvest at a lower level.”

It will be interesting to see the dynamic at work in Europe with the ECB purchasing considerable amounts of bonds into the market, he adds. “One can expect to see lower yields, flatter yield curves and a lower euro. This trend will continue as we have 80 weeks of QE ahead of us. This leads to a huge imbalance between supply and demand of bonds. There will be an estimated €250bn of government bonds net supply in 2015  and the ECB will be buying €45bn per month.”

Bond prices may even need to rise to artificially high levels to entice pension funds and insurance companies to part with existing holdings, and this could push up not just European bond prices but asset prices globally. This supply squeeze contrasts starkly with the US experience, where the Fed has never had to contend with liquidity constraints, shortfalls or disorderly pricing.

While equity investors have been switching to dividend-paying defensive stocks, fund managers with bond-only mandates have been switching to peripherals and corporate bonds, where the yield curve at the shorter end remains quite steep, giving potential for capital gain. Despite the low spreads, credit risk is arguably improving and absolute returns could yet be positive.

In the UK recently, sterling has been weaker even against the euro, which supports the corporate sector. While the consensus had been for a UK rate rise in the first quarter of 2016, much depends on the the general election on 7 May, which may be stoking the market in the short term. There is also a sense that greater stability will be required for a resumption of normal rates.

“We are overweight the UK versus the eurozone because the UK is relatively cheap and cannot decouple completely from European markets,” says Ralf Schreyer, manager of the €693m DWS Eurorenta fund. The UK money market curve had priced in an interest rate hike shortly after the election, which is being priced out now and he believes there will be no rate hike this year because of the growth and inflation correlation between the UK and eurozone. 

“A lot of our competitors and investors who are looking for yield pick up are adding peripheral and corporate bonds,” says Mr Schreyer. “New issues are oversubscribed multiple times and this strategy works for the time being, but with yield spreads for corporate bonds at pre-crisis levels, those bonds are not cheap any more and we prefer to actively manage duration, curve and country spread.”

Fund managers are being highly selective in their holdings.

 “Due to our expectation of low volatility in core euroland government bonds, we are still positive on euro-denominated spread asset classes like corporates bonds as well as emerging markets,” says Bernd Gentemann, senior portfolio manager at Union Investment. 

In general he likes the very long end of the yield curve which is supported by the global low inflation environment, high central bank liquidity and the need for asset managers to hunt for yields. “Over the last 12 months we had a bias to be duration overweight compared to the benchmark universe average. With an increasing amount of assets approaching negative yields in euroland core markets, in combination with the ECB’s weak euro policy, it is becoming more and more relevant to globalise portfolio strategies. To give an example, we are actually overweight in the Turkish local bond market.”

Some asset managers, such as Baring, like the German market despite growth of nearly 40 per cent already on a total return basis from the lows in October, arguing QE’s impact on euro competitiveness will continue to help Germany’s niche, high added value exporters. 

Higher quality peripherals such as Spain have seen inflows, although the election will be a test, as more extreme political parties worldwide have garnered support in the face of austerity and widespread unemployment. 

“Fundamentally Spain is progressing nicely, with a tighter labour market, positive real GDP growth, a positive trade balance and an improving fiscal imbalance,” says Mr Dealto at Fischer, Francis, Trees & Watts.  Inflation remains a concern, as it does in most of continental Europe, but he predicts it should return to positive territory in 2016. 

“The tide is definitely turning and we play this within our European aggregate portfolios through long positions in Spanish government bonds and also through selected covered bonds, such as Cajas Rurales and Banco Popular,” says Mr Dealto. “The caveat in Spain is related to the election cycle, where the rise of new parties such as Podemos and Ciudadanos are likely to challenge the bipartisan political system. This will be tested over the year, but will culminate in national elections in the fourth quarter.”

Investment grade credit and peripheral bonds in countries such as Spain and Portugal is positioned to do well despite the low growth and inflation because low rates reduce the risk of default. Lyndon Man, senior portfolio manager for Invesco’s global IG credit funds, drills down through the capital structure into subordinated debt in the peripheral financial world, as banks continue to deleverage, and also likes cross currency basis bonds issued by the big banks in dollars and sterling.

The ECB is trying to reduce the fragmentation between core and periphery, by compressing the spread between them by stimuli such as longer-term refinancing operations to help facilitate SME borrowing. But Mr Man is cautious of high yield as a sector and holds nothing more lowly rated than a single B, because, although there are idiosyncratic opportunities, he believes ECB policies are creating spread compression indiscriminately.  

Value lies in the corporate sector

RBC Wealth Management’s head of fixed income Håkan Enoksson believes the best value in the European bond space is probably in the corporate sector, where spreads have widened owing to new issuance and which should benefit from the second wave effect of QE, widening the asset class’ investor base. 

He prefers a target duration of five to 10 years, which offers the prospect of further spread compression, particularly in the financial sector, which has underperformed its peers in recent months as well as consumer goods and services. In financials, senior secured bonds and lower tier two bonds are the preferred part of the capital structure.

Actively managed funds are required for this asset class because in fixed interest, a traditional passive fund will be weighted to the most indebted companies, Mr Enoksson says.

James Knowles, head of fixed interest at Psigma, would be reluctant to recommend a general European bond fund but he likes particular assets on a specialised basis such as the asset-backed market. These still look good value yielding 6-7 per cent, and Mario Draghi has promised the ECB will buy a large swathe of the market. Mr Knowles also likes selective bonds at the illiquid, difficult end of the triple C market.

VIEW FROM MORNINGSTAR: Performance piques investor interest

The eurozone bond market has delivered strong absolute returns over the past 12 months, as shown by the 8.9 per cent return of the Morningstar EUR Diversified Bond category over the period (to 16 March 2015). 

Markets have reacted positively to the ECB’s monetary policy activism, and in particular to its January 2015 announcement of a QE programme involving the monthly purchase of €60bn of government bonds (a larger amount than initially expected) until at least September 2016. The ECB’s key interest rate has been at an absolute low of 0.05 per cent since September 2014, while the deposit rate is in negative terrain at -0.20 per cent, with an apparent commitment to keep these ultra-loose policy settings for an extended period. 

Furthermore, GDP forecasts for 2015 and 2016 in the eurozone are on an upward trend, as the combined effect of a weaker euro and the fall in oil prices are seen as key factors allowing for an improved performance of domestic demand. While the standoff between the Greek government and the eurozone brought episodic volatility in 2014, bond markets do not appear overly concerned with the potential of contagion to other regions. Finally, investor demand remains very strong, as evidenced by strong inflows for the asset class throughout 2014, both in the government and the corporate bond universe.

In this context, Pioneer Funds Euro Aggregate Bond, which has a Morningstar Analyst Rating of Silver, outperformed peers by 1.4 percentage points in 2014. The fund continues to rank in the category’s top half over the first quarter of 2015. 

Experienced lead managers Tanguy le Saout and Cosimo Marasciulo have worked together at Pioneer for almost 15 years and have led this strategy since inception. Their approach is based on a number of diversified strategies (ranging from duration positioning to momentum, volatility, inflation and marginal foreign currency exposure), whose contribution to the overall portfolio depends on the team’s macro scenario. 

In 2014, as interest rates trended lower, the fund benefitted from longer duration positioning compared to peers. Against its benchmark, the main positive contributors were exposure to quasi-sovereign bonds and interest rate positioning in Scandinavia (long 2-year Swedish rates). 

Candriam Bonds Euro, which holds a Morningstar Analyst Rating of Neutral, also outperformed 70 per cent of peers in 2014. The fund benefitted from fairly aggressive country allocation in the sovereign bond pocket, overweight on Italian and Spanish government bonds. The strategy is managed through a collegial approach by Candriam’s global bond team, led since 2013 by Nicolas Forest. Despite recent team changes, it is reasonably stable and of sufficient size. 

However, we do not believe this fund has an edge over competitors, either in terms of team or process. Long-term results have also been middling, as the fund has performed in line with the category on a risk-adjusted basis, but lagged its benchmark index over three and five years up to the end of February 2015.

Mara Dobrescu, Manager Research Analyst, Morningstar