Institutional investors may want to consider including European sovereign debt to capture higher yields.
“We welcome the return of risk pricing to sovereign debt markets, a component that was largely ignored circa 1999 to 2007.”
— David Blake
director of global fixed income, Northern Trust
Despite the negative headlines surrounding the economies of European Union (EU) countries in recent months, institutional investors may want to consider European sovereign debt as part of their portfolios. The very issues that cast European debt into the spotlight have also served to dramatically increase the spreads among EU bond issues.
When Greeceâ€™s credit seemed highly questionable last spring, the premium the country had to pay on its bonds compared to Germanyâ€™s debt issues rose dramatically â€“ from 2% at the beginning of 2010 to nearly 10% in the midst of the crisis in May. Spreads on bonds issued by Portugal, Ireland and Spain also showed sizable increases, a scenario that was repeated in September, and again in November, when anxiety mounted once again regarding the financial stability of the European periphery.
To be sure, greater yields entail greater risk, as evidenced by the wave of rating downgrades affecting the periphery. Moreover, a comprehensive rescue package worth nearly $1 trillion that the European Commission and the International Monetary Fund co-sponsored has not completely steadied market nerves.
Continued utilization of the â€śrescue packageâ€ť facilities or a â€śrestructuringâ€ť of outstanding government debt remains a high probability event for peripheral Europe, where underlying economic growth and subsequent tax revenue may not support or sustain the maturity profile and absolute amount of current outstandings.
Nonetheless, sovereign debt with a â€śmade-in-Europeâ€ť label can still provide a potentially attractive return. The question is at what price and under what strategy.
â€śIf not an integral portion of an asset allocation strategy today then investing in European sovereign debt at this point may be a very tactical approach,â€ť advises Wayne Bowers, chief executive officer, Northern Trust Global Investments, London. â€śAlthough explicit evidence of such investment is difficult to assess at the moment, it would not surprise me, especially because some of the peripheral EU countries, such as Spain and Italy, have seen spread compression in recent weeks.â€ť
Bowers says the recent narrowing in spreads is a sign that overseas investors are still comfortable with taking on or increasing positions in the less creditworthy countries. Explicit public comments by Chinese Premier Wen Jiabao on buying and holding Greek government debt is a case in point.
For David Blake, director of global fixed income for Northern Trust, investing in EU sovereign debt is a prospect that needs to be framed in the context of investor risk appetite.
â€śThere are undoubtedly opportunities in the current spread environment,â€ť Blake explains. â€śThe dynamics within Eurozone debt markets have created the potential opportunity for well-informed managers to add value above and beyond more traditional rate considerations.â€ť
Blake adds that the spreads within the Eurozone are at â€śhistoric widesâ€ť and that such divergence is long overdue.
â€śWe welcome the return of risk pricing to sovereign debt markets, a component that was largely ignored circa 1999 to 2007,â€ť he says. â€śAs fundamental managers, we are firm believers in risk premia and would argue that the current situation is much more reflective of the relative strengths and weaknesses of individual sovereigns than was previously the case.â€ť
Blake is far from alone in welcoming a wider spread in interest rates within the EU. Many observers, including foreign exchange maven George Soros, have complained that EU bond yields were artificially narrowed following the introduction of the Euro as a common currency in 1999.
John Jay, senior analyst for the Boston-based consulting firm Aite Group, points out that sovereign debt has historically undergone a periodic reappraisal.
â€śEverybody got into a real dither with the Euro periphery, so there is a mad rush to devalue the sovereign debt, and in that scenario, the bet on U.S. Treasuries is the safest,â€ť Jay says. â€śThis is not a new consideration. Every five to 10 years there is a revisiting of sovereign debt depending on the current crisis.â€ť
Still, Jay advises caution. â€śSuch diversification does not come for free,â€ť he notes. â€śIn the end, an investor has to look at the entire portfolio from a total return standpoint, weighing the proportional risks against the rewards.â€ť
Bowers agrees, and says investors need to research sovereign- debt issuers just as they would if they were buying high-yield or investment-grade bonds, rather than relying on the rating agencies to grade a debt issuer.
Bowers points out that despite having triple-A ratings, the various countries could well be at different points in their economic cycle with regard to monetary and fiscal policy.
â€śYou do need to understand the political risk, the fiscal policy stance, the monetary policy and the economic growth fundamentals to gauge a debt issue, and its risk, return and default probability,â€ť Bowers says. â€śAll of this goes into the opinion of whether interest payments can be made on time and the bond matures at par.â€ť
Blake cites Ireland as an example of the need to delve deeper into EU debt issuers.
â€śIn September, Ireland canceled its remaining bond auctions for 2010,â€ť he points out. â€śIt was able to do so because it has pre-funded itself through mid-2011 with longer-term debt issues. Greece, on the other hand, never had the option to sit it out. Would-be investors must pay attention to such details.â€ť
Another important detail is the investor base, according to Blake. Spanish banks, he notes, are â€śnatural buyersâ€ť of Spanish government bonds, but Ireland has no natural buyers of its debt and is thus more reliant on growth, subsequent tax receipts and eventually external support packages.
For those investors who do seek to broaden their portfolios with higher income-producing assets, there are a number of measures they can take to manage their risk, such as diversification.
“Investing in European sovereign debt at this point may be a very tactical approach.”
— Wayne Bowers
chief executive officer, Northern Trust Global Investments, London
â€śWe do see investors who hold little diversification when it comes to sovereign risk,â€ť Bowers says. â€śThey tend to have all U.S. Treasuries or U.K. gilts or JGBs (Japanese Government Bonds). As an alternative, investors can buy different currency denominated issues from those issuers. Or they can use the foreign exchange market to hedge their exposure back to their preferred base currency.â€ť
Blake advises risk-adverse investors to focus on debt issued by core and semi-core EU members, such as France, Germany, the Netherlands and Belgium. Although the EU leaders dwarf the economies of the latter two countries, their reliance on inter-European commerce and labor is such that they tend to stay more appropriately aligned with EU fiscal and monetary requirements.
Another risk management tool institutional investors might consider are credit-default swaps (CDS), though here too they should proceed with caution.
â€śThe whole CDS market compared to U.S. Treasuries is not very liquid,â€ť says Aite Groupâ€™s Jay.
Bowers concurs. â€śWe would not necessarily recommend the CDS market in terms of the liquidity and depth of most government bond markets,â€ť he notes. â€śInstead, we would recommend cash-based investment strategies, that is, to actually own the bonds. Additionally, if you are looking for protection, there is a very deep exchange-traded government bond futures market that exists for major government bond markets.â€ť
However, Bowers does see a â€śtertiary levelâ€ť where government CDS might be used for specific protection.
â€śEach yield curve is slightly different for each country,â€ť Bowers says, â€śso if you are looking to own a collection of government bonds for European countries and you are worried going forward about a specific country, then you could use, say, an Italian five-year government CDS to protect you against any adverse movements in your Italian government bond position.â€ť
In terms of short-term sovereign debt opportunities, Blake believes investors may want to widen their scope to consider supra-national and agency bonds as well. In the so-called SSA market savvy investors are able to access higher yielding bonds in return for diminished trading liquidity, often without any degradation of credit quality. These would include entities such as the European Investment Bank and the German agency KFW.
For long-term opportunities, Bowers advises institutional investors to strike a balance between risk appetite, diversification and return expectations.
â€śIf an investor did not have a broader view with some appetite to take risks, then certain investment classes would not exist, such as low quality investment-grade or high-yield bonds,â€ť he says.
Overall, Bowers believes that institutional investors tend to underestimate the strength of the Euro and the EU.
â€śThe focus on peripheral European countries is totally appropriate based on issues and challenges these countries face. However, what seems to be ignored or discounted is that these countries account for around 10% of the regionâ€™s economic activity,â€ť Bowers says. â€śCore Europe, especially Germany, accounts for the overall majority of economic activity for the region and has been growing steadily, with continued momentum in spite of various austerity measures in place. Some investors just look at the Euro as a hard currency unit without necessarily understanding the political will and unity that actually exists.â€ť
Jay also notes the strength of Europe. â€śIn spite of all their austerity measures, the German economy is actually expanding at a healthy clip,â€ť he states. â€śIf they can do that without printing money, they are indeed in a better economic situation in the real economy compared to countries that are printing money.â€ť