Recurring phases of low volatility in the fixed income market over the past few years have forced investors to focus on single events that could potentially provide opportunities. This is why we have repeatedly turned our attention to the periphery, hoping that political uncertainties and social unrest may finally provide the chance for which we have all been waiting.
In reality, the Catalan independence movement in Spain and the elections in Italy did little to move the market and the spread between 10-year government bonds versus 10-year bunds is currently trading at its narrowest since 2010 for Spain and the tightest since 2016 for Italy. And although there is still no clarity regarding the formation of a government in Italy, and the media is starting to talk about another election as soon as July, the Italian yield of the 10-year BTP has tightened more than 15 basis points since the March 4 elections when it was trading slightly above 2%.
Another and more impressive story is to be found in Portugal and the performance of that country's government bonds following rating upgrades from S&P and Fitch. The 10-year Portuguese government bond yield has been declining from 3% in July last year to trade at 1.7%, which is 10bps points below their Italian BTPS counterpart. While it is true Italian issues may be perceived as riskier due to political uncertainty, they still remain more liquid instruments compared to their Portuguese equivalents.
The rally of the periphery has been welcomed by many, however, now that there is less and less room for tightening versus German bunds, many are starting to look away from these countries and turn their attention to the last country of the periphery that can provide an above average yield.
The Greek 10-year government bond still offers a 4% yield, which is more than double that carried by comparable European government bonds and well above the yield offered by many high yield corporates in EUR.
It is impossible therefore not to wonder whether the risk entailed by such a high yield is worth taking, especially when investing in euro, as in the past few years such investing has become a very boring exercise given the general low yield environment.
This year is the eighth year since Greece’s first bailout and the day that marks the exit of its bailout programme is August 20. However, we are nowhere near a complete resolution to the Greek crisis as a raft of important topics must be tackled before the dust finally settles. The elephant in the room is negotiations to ease €320 billion of debt, which it is currently dividing lenders. One camp, which include the International Monetary Fund, the European Commission and France, believes that unconditional debt relief must be granted, while the other camp, represented by Germany, believes that strict conditions to debt relief are necessary as this would guarantee repayment.
Imposing conditions on debt relief implies that if the Greek government breaks a clause, the relief would be suspended. This is an important point because the country is still wallowing in debt: it accounts for 180% of gross domestic product and should Greece be granted unconditional debt relief, some pressure would be eased and complications involving social unrest and radical anti-euro support would be less likely.
The IMF plays a very important part in the debt talks as any positive commentary from the international fund about Greece would send a positive signal to the market, especially concerning the sustainability of the country's debt.
If all the stars align, we can expect the spread between Greek government bonds and bunds, which at the moment is some 305bps, to tighten to levels previously seen nine years ago, around 200bps, meaning that if the 10-year bund yield continues to trade at current levels of 0.55%, the 10-year Greek government bond yield can fall to 3%.
Figure: Greek, Italian, Portuguese and Spanish 10-year bond yields (Source: Bloomberg)