While markets remain relatively sanguine about what’s happening in Greece thus far, the situation is interestingly symptomatic of one of the key flash points for Europe: reforming public finances. Investors should expect markets to grapple with that factor in various guises over the next several years.
Institutionally speaking, Europe is a much better place to be an investor than it was a few years ago. Several of the clouds over the region have started to clear, with weak bank financing and sovereign stress having been largely resolved by the actions of the ECB to improve the credit quality and lending health of banks (via the AQR, etc) and the support of quantitative easing.
The remaining hurdle for the Eurozone remains much needed structural reforms – as such we should expect the theme of anti-austerity to remain a flashpoint.
We currently see significant value in Spanish and Italian sovereign bonds and think they could go as much as 50 basis points lower in spread than current levels. When the ECB actually starts buying bonds in March as part of the QE programme, this will create a net negative supply – a powerful alteration of the supply and demand dynamic.
With nearly a quarter of all Eurozone government bonds currently on a negative yield, it’s certainly reasonable to see relative value in Spanish and Italian sovereign bonds with substantial positive yield.
We expect Spanish ten year sovereigns could go to as low as 1.0% yields by the end of this year or even before. Investors should remember that central banks are going to drive yields lower and lower in an attempt to force portfolio readjustment into riskier assets and in turn stimulate economic activity.
An education
So, in our view the lessons learned for bond investors in today’s environment are:
• Don’t underestimate central banks – they can still surprise us and they are powerful buyers
• Just because yield is negative doesn’t mean it can’t go more negative – keep relative perspective in mind
• Even at these levels, fixed income retains its capacity to surprise. And to deliver returns. Just take the case of Japan as an example. JGBs racked up total returns of nearly 5% in 2014 despite remarkably low yields.
Applying the lessons to your investments
So how do you invest with all of this in mind?
• US high yield: continues to look attractive with an average 6.4% yield (particularly relative to negative yields on certain government bonds) but requires a selective approach to navigate the index’s energy exposure (85% of the market is ex-energy and therefore a net beneficiary of falling oil prices).
• European high yield: not so “high”, at only 4%, but still interesting. Corporate borrowers have a supportive central bank, an improving economy, a boost from the weakening currency and falling oil prices, all of which are positive fundamentals. Not a bad trade when the yield on equivalent duration German government bonds (ie 5 years) is in negative territory.
• Investment grade corporate: US yield has been pretty stable around the 3% mark but spreads have started to diverge: tightening in Europe, widening in US. On a relative basis, European corporates are looking expensive relative to the US creating opportunities in the US market.
• Emerging market debt: there’s a tendency to assume all emerging markets are commodity exporters but there’s a big differentiation, so investors need to look at emerging markets on an idiosyncratic basis. There will be winners and losers. Russia is currently offering very high yields but to get that yield you have to be prepared to take on currency risk. The dollar strength is affecting all markets but that’s not to say that some EM currencies haven’t performed well relative to other developed currencies.