Inflation situation spooks European bond markets

European sovereign debt markets have produced highly divergent performances over the last year,  with the bonds of the higher-yielding peripheral nations surging as investors returned to markets they had shunned during the region’s debt crisis. 

Greek bonds were the leading performer among the currency bloc returning 32 per cent this year to April 10, and 47 per cent over a 12 month period, according to Bloomberg World Bond Indexes, while Italy’s bonds delivered 6.1 per cent in 2014, outstripping the 2.8 per cent for German bunds.

Looking ahead it is hard to find pockets of opportunity because most of the gains in the peripherals have arguably been made. However, the sale of long-term debt by the Greek government in early April was eight times over subscribed. The €3bn euros worth of five-year bonds, which marked Greece’s return to the capital markets following the near-collapse of its economy  in 2010, attracted investor orders running at €20bn, and was offered at a yield of 4.95 per cent, far lower than analysts had anticipated.

This was in stark contrast to the Chinese government which has been unable to sell all the bonds it offered at an auction in April, its first such failure in a year amid concerns its economy is faltering.

However as  the rehabilitation of peripheral Europe takes shape, investors have begun to baulk at current yield levels which have priced in all the positive news. Ten-year yields are now at record lows with the average yield to maturity on bonds from Greece, Ireland, Italy, Portugal and Spain falling to 2.24 per cent on April 10, the lowest in the history of the eurozone, according to Bank of America Merrill Lynch indexes, and manifestly low compared with their peak of 9.55 per cent in 2011.

Moreover, Greece’s rehabilitation owes a great deal to confidence that Germany will bail it out if anything goes wrong, rather than allow a default. After all, it is still rated as “junk”, at Caa3 nine notches below investment grade by Moody’s, and at B- by Standard and Poor’s and Fitch.

This also means that while core metrics such as Germany’s level of indebtedness may appear to be improving, it may yet be expected to shoulder part of the burden of its more indebted neighbours. If the ECB is allowed to conduct Outright Monetary Transactions and buy the sovereign debt of individual eurozone states, this could cause real damage. The German constitutional court recently ruled that such a plan would contravene EU law and is beyond the ECB’s mandate in any case.

Furthermore, although core European economies have typically shown signs of improvement, their growth and debt fundamentals have remained relatively unchanged. Recent improved sentiment  is largely a reflection that the ECB will do anything in its power to prevent a break-up of the monetary union, which was the market’s big preoccupation  last year.

The inflation issue

The focus has now switched to regional deflation as eurozone inflation has hit a cyclical low, not helped by the ECB choosing ‘internal devaluation’ to resolve the crisis.

Arguably the absence of inflationary pressure in the core countries is good for bonds, particularly in the peripherals, as it means interest rates in the eurozone are likely to lag US rates for some time. But investors are watching for signs that the ECB will introduce new stimulus measures, including asset purchases, following  President Mario Draghi’s signal in early April that policymakers have unanimously agreed  to use unconventional measures if required, to boost inflation, which is now running at its lowest rate in more than four years.

Rüdiger Kerth, Union Investment

“We don’t think the ECB will hike rates in the near future as disinflation is a major subject for the region, so it may reduce rates again, which would support the peripherals where interest rates are still high,” says Rüdiger Kerth, fund manager at Union Investment, who believes scope remains for further tightening in peripherals.

“The inflation numbers are well off ECB projections and so it is clear that they may need to take action to bring it back to 2 per cent,” he says.

With inflation well short of its target, approximately 1 per cent annual inflation for the next three years, and less than 1.75 per cent per year over the next decade, and in the absence of  unconventional measures,  a case is building for the ECB to deal with the inflation issue before it further unsettles the market. 

“We believe the ECB could engineer 1 per cent inflation enabling it to reach its target by doubling the size of its balance sheet,” says Jonathan Baltora, fund manager of AXA WF Universal Inflation Bonds. “The ECB has now given strong hints that it is prepared to implement bond buying to prevent deflation. Over a 12-18 month horizon, central banks can engineer an inflation boost using currency depreciation, as has been seen in the US, the UK and Japan through QE.”

Leaked ECB figures showed that increasing the size of its balance sheet from 50 per cent to 100 per cent could engineer a 20 per cent drop in the value of the euro that would, by historical standards, result in close to an extra 1 per cent inflation, explains Mr Baltora.

“In addition, employment expectations remain key and a survey by the European Commission confirms that we are probably at a turning point,” he says.   

Some investors have reacted to Mr Draghi’s comments by increasing their exposure to  European real interest rates, and a flurry of inflation-linked bonds is expected in the spring, including Spain’s inaugural inflation-linked issue. Mr Baltora has boosted his own fund’s exposure to French and Italian inflation-linked bonds.

However, Anne Beaudu, global fixed income portfolio manager at Amundi, believes inflation is strengthening, thanks to positive seasonality and stronger activity.

“There will be an accommodative bias, so in the short term rates will stay lower,” she says. “We think inflation is going up a bit even if it is at a low point now. Growth is accelerating and there is a direct relationship between growth and core inflation with a 1-1.5 year lag. Without tax effects inflation has in fact begun to drift higher, and the argument is that it is sensitive to energy and food and we have seen pressure in their supply side in recent weeks.”

The most well-liked sector is financials. “The Asset Quality Review programme will provide greater clarity to investors in European banks because where otherwise each member country’s regulators used different approaches to account for problem assets, there is now a unified approach,” says Dominick  DeAlto, global head of 
multi-sector fixed income at BNP Paribas Investment Partners.

“We will learn that a much smaller percentage of banks are at risk (perhaps 18 per cent), not nearly as many as we once thought when the crisis began,” he says. “The next stage of the programme will be to ring-fence these bad banks which will give even greater confidence to banking system investors.”

Mr DeAlto thinks monetary policy could and should ease in Europe, and that the ECB’s promise to “do whatever it takes” is credible, so they are long duration in the periphery, and also like corporate bonds and asset backed securities.  Overall the funds are 15-20 per cent overweight corporate bonds and other spread sectors and he thinks the fundamentals and default rates are very favourable at this point in the cycle.

Franklin Templeton International Bond Group’s senior vice president John Beck also believes AQR has created opportunities and recommends an overall defensive duration stance diversified across countries, with a preference for select opportunities in emerging-market and corporate debt.

However, clients should be wary of parts of the banks’ capital structure such as senior unsecured bonds and lower tier two bonds, warns Håkan Enoksson, head of UK fixed income at RBC Wealth Management and he does not like deeply subordinated bonds or Cocos,  which he thinks are still immature and vulnerable if there is stress in the market.

European bond markets may also be impacted by the investigation by US regulators into banks’ trading profits from new issues. The US Financial Industry Regulatory Authority is examining which middlemen have earned unusually large profits on bond deals, which could lead to a regulatory instruction to banks to reduce spreads on certain trades, or even to enforcement action to stop investors quickly selling newly acquired bonds for a quick profit to investors who were initially excluded from the deal. The inquiry is also focusing on investors’ troubles buying and selling bonds when credit markets tumbled in May last year after the Fed signalled intentions to wind down its bond buying. 

Vanishing value

In 2013 the biggest driver of returns in this sector was the improvement in the periphery  with most countries improving faster than anticipated, and it damaged investors who had avoided those markets. Looking ahead, returns will not be so easy to come by.

Arnaud Gandon, CIO at $8.4bn (Ä6.1bn) investment/wealth management firm Heptagon Capital,  does not  see “any good value anywhere along the pure vanilla credit spectrum. Everywhere we look – investment grade, high yield or sovereign debt, yields are low and not compelling.” Last year Heptagon made a good profit on allocating to a specialist manager  that bet on the convergence of the periphery following Mario Draghi’s speech in July 2012.

“We are sympathetic to the idea that there is little inflation in Europe but despite that the yields on offer are not attractive,” he says. For example, the yield on investment grade corporates at 1.9 per cent on a four to five year duration does not compensate investors for the risks they are taking. In February yields went to 1.75 per cent on investment grade corporate debt, almost touching the lows of 2007, as yields are a direct result of zero rates pushing them to extremely low values.

“People make a case for corporate bonds by arguing that default rates are low but we take a different view,” says Mr Gandon. “For us if the default rate is low then that is reason to be cautious as it cannot easily get lower. You need to buy investment grade when defaults are high so that they can improve. It is the same with volatility – you should invest when the VIX is high.”

The current market is one for flexible managers who can move across different markets without the shackles of a rigorously enforced benchmark. Such managers have been able to make a 15 per cent return annualised over the last three years.

The one area of fixed interest where Heptagon Capital is still invested is in a flexible and dynamic fund, which has the ability to hedge duration risk and generate a return between relative value trades.

“We focus on specialist independent boutique managers who are under the radar – not the big brand names because if you look at the European high yield corporate debt, it is a small sector, so we need managers who can buy small paper and be nimble while the big managers have to buy the most liquid and largest components of the benchmark,” he says. The market for high yield and investment grade is not what it used to be, claims Mr Gandon – liquidity has deteriorated a lot in the last few years so managers who can invest in smaller sizes have more opportunity to generate alpha.

The other issue that has exercised wealth managers recently is the Russia-Ukraine situation which has driven some reversal into safe havens. “Our views on the eurozone are the same as before, but we have taken out some of the riskier Russian issues – the big usual suspects – and rebalanced the portfolios where necessary,” says Håkan Enoksson at RBC Wealth Management. “In an advisory capacity we are recommending clients switch to other European domestic stories where we feel more comfortable with the risk, otherwise there are too many exogenous drivers.”

View from Morningstar: Funds battle to beat benchmark

European bonds have proved relatively resilient over the first quarter of 2014: as of March month-end, the Morningstar EUR Diversified Bond category had returned 2.5 per cent, which is already higher than its return for the whole of 2013 (1.65 per cent). In spite of ongoing tapering talks, European markets have not overreacted to the news of potential hikes in interest rates. Other favourable trends, such as slightly better growth prospects, particularly in the eurozone periphery, and continued improvement in European companies’ balance sheets, continued to support demand for the asset class.

One of the best performers was BGF Euro Bond. Manager Michael Krautzberger runs a diversified portfolio, seeking to add value through multiple performance drivers and relative value bets and the fund boasts a steady record of outperformance. Over five years, the fund has beaten 86 per cent of its competitors.

Raiffeisen-Euro-Rent also continued to deliver over the period. In the past few years, the fund has tended to display a structural overweighting to credit, but that was far from being the only contributor to performance. The fund has consistently outpaced peers in a variety of market conditions, not least thanks to its reasonable fees.

HSBC GIF Euro Bond was equally successfu. Manager Jean-Philippe Munch’s decision to allocate the portfolio between government and corporate bonds is not constrained by benchmark weights or tracking-error constraints, but he has historically made good use of this substantial margin for maneuver. As of Feb 2014, the fund’s portfolio continued to show a relative preference for corporate bonds.

Mara Dobrescu, fund analyst, Morningstar