Given the somewhat tempestuous times we have seen in Europe recently, one can hardly blame investors for being a little nervous of the region. However, with good returns from both government and corporate bonds last year it is clear that we cannot write Europe off.
So what has gone wrong? Why is it that so many investors are still wary? And more importantly, do fixed income opportunities still exist?
Miscalculated risk
The birth of the euro meant a huge convergence of interest rates in the eurozone. Convergence brings to mind an image of things coming together. Arguably this should have been the case in Europe, with peripheral yields benefiting from the support which being part of a single currency area brings, and core yields rising to reflect the extra potential burden that such support could entail. The reality was slightly different, and while the peripheral countries did benefit from the union, seeing their yields tumble to levels close to those of Germany, core yields did not rise accordingly.
For most of the period from the inception of the euro until mid-2008, the euro-bloc traded almost as one nation, with little
differentiation being made between the sovereign states.
In retrospect this seems a miscalculation of the risks involved. While the yield on the Portuguese ten-year blowing out to over 16% early in 2012 was perhaps something of an over-reaction, in general the wider spreads between the peripheral and core markets, reflecting the different risks in the various markets, surely make more sense.
Mammoth returns
They also offer potential opportunities for investors. Last year, for example, Portuguese government bonds returned 58%, while a composite index of PIIGS countries’ government bonds returned 18.5%.
In addition to the opportunities presented by a volatile and jittery market, there are other fixed income options in Europe, which could be of interest to investors who are still nervous of the macroeconomic situation. Corporate bonds are the obvious one as they are issued directly by companies and therefore not necessarily tied to the fortunes of individual governments.
A couple of points of caution here. First, it is always important to look at the source of a company’s earnings: for example where geographically are revenues coming from, how cyclical is the nature of the business, and so on. Some European corporate bonds can get beaten up for being domiciled in Europe when their revenues have little or no correlation to the European economy.
Second, while volatility presents opportunities, make sure you are being paid for the risks you take on. At the time of writing European high yield bonds were yielding 4.8% (yield to worst), but US High Yield bonds just 5.8%. While this is not really a fair comparison (the US index is both longer duration and lower credit quality than the euro index), the point is that it is vital to understand the risks and to ensure you are rewarded appropriately.
Outside the box
Another area which could be of interest to investors unwilling to take on traditional fixed income risks in Europe is that of property debt. We have recently seen several asset managers keen to launch investment companies in order to take advantage of opportunities in listed and unlisted property debt in the UK and various European countries. Such funds can provide investors with a high and stable income stream, while giving them the comfort of being high up (often at the top of) the capital structure.
European fixed income markets have certainly provided plenty of excitement in the past few years and continue to present opportunities. Investors may have to think outside the box a little more this year, however, taking on risks that will yield appropriate rewards or looking at alternative parts of the fixed income markets.
Whether or not this means that Europe is the place to invest is down to individual preferences, but for those with the risk budget – and nerves – to take the volatility, the rewards are there.
