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Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.

Bonds
Picture of Althea Spinozzi
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  The overwhelming demand observed during last week's ultra-long sovereign bond sales suggests investors are confident central banks will deliver aggressive rate cuts by year-end. However, if policymakers were to prove cautious about cutting rates, these positions may incur significant losses. As the economy remains robust in the United States, and inflation remains above central banks' target on both sides of the Atlantic, we remain cautious and prefer maturities of up to ten years while taking a selective approach for ultra-long duration.


In recent weeks, markets have experienced a significant shift.

Bond futures started the year pricing in the possibility of seven rate cuts in Europe and the U.S. Still, in six weeks, odds for rate cuts dropped to 4.5 (approx. 115 basis points) this year, driven by policymakers’ pushback against early and deep rate cuts and robust economic data. Such a move caused U.S. Treasury and European sovereign yields to rise.

However, investors are not convinced by the “high-for-longer” message that central bankers are sticking with, particularly in Europe, where the sluggish economic growth in the region and disinflationary trends contradict the ECB’s holding stance. Consequently, the contrast between policymakers' holding message and markets' expectations for rate cuts has created a window of opportunity for investors looking to take advantage of high yields ahead of a dovish ECB tilt.

Last week’s busy ultra-long sovereign bond issuance has shown evidence of buy-the-dip solid demand and duration extension on both sides of the Atlantic.

Investors welcomed an avalanche of 30-year sovereign bonds last week.

Below is a list of ultra-long sovereign bonds sold by various countries last week:

  • €5 billion 30-year Belgium bonds (BE0000361700). The new Belgian ultra-long bonds pay a coupon of 3.5%. Final books were above €60 billion, with the bonds receiving twelve times more bids than the amount offered.
  • €6 billion of 30-year Bunds (DE000BU2D004). Initial guidance indicated that the new issuance would have offered 5.5bps over the benchmark, but with high demand (books totaled bids above €74 billion), the issuer was able to secure a tighter spread: 4.5bps over the benchmark. The yield offered by these securities at issuance was 2.537%.
  • €6 billion of 30-year Spanish Bonos (ES0000012M93). The bonds were priced with a yield of 4.002%, two basis points tighter than the initial guidance of +14 basis points over the benchmark due to high demand, with books exceeding €83 billion.
  • €1.426 billion of 30-year French OATs bonds (FR001400FTH3). The auction received a total of €4.128 billion in bids, securing a bid-to-cover ratio of 2.89, compared to 2.32 the previous month. At their reopening, bonds paid on average 3.27% in yield.
  • £2.5 billion 30-year green Gilts (GB00BM8Z2V59). The reopening received an unprecedented £7.636 billion in bids, oversubscribed by 3.05x, the most since April 2020. The bonds were sold with an average yield of 4.56% at issuance.
  • $25 billion 30-year U.S. Treasuries (US912810TX63). The auction saw indirect bidders rising to 70.7%, the highest since August 2023, but direct bidders dropping to 14.5%, the lowest since August 2020. The high yield at issuance was 4.36%

As yield curves steepen, ultra-long bond duration becomes more attractive, although risks remain.

The reason behind buy-the-dip demand may go beyond expectations that central banks will begin to cut rates this year as inflation reverts to its mean. A gradual steepening of yield curves, which started last year, and short future position covering in the U.S., may have also played a critical role in igniting investors' demand for the long end.

Today, investors can secure a small, although better, pick up in 30-year bonds than 10-year notes compared to the past couple of years.

The most striking example is the one of the Bunds, with the spread between 30-year and 10-year Bunds around 20 basis points, one of the highest since it returned positive in March 2023 after being negative for almost six months. A negative 30/10-year Bund spread implied investors received a lower return to hold 30-year Bunds than 10-year Bunds.

As yield curves continue to normalize and become steeper, the spread between 30-year bonds and 10-year notes will continue to widen and normalize around 100 basis points. While it is true that an aggressive cutting cycle is likely to benefit ultra-long maturities, it is also true that a first-rate cut by central banks may work the opposite way for the duration as a classic “buy the rumor, sell the news” drives investors to take profit on their ultra-long position.

To add to uncertainties surrounding the future performance of ultra-long bonds is how the cutting cycle will pan out. If central banks cut rates cautiously, there may be limited room for upside for duration. If rates remain higher than what markets were accustomed to before the COVID pandemic, that may be negative for the long term.

We already see discrepancies between what markets are pricing and what economists expect. The bond futures market expects the deposit rate to fall to 2.75%. However, the recent Bloomberg’s euro area economic forecasts survey shows a less aggressive cutting cycle, with the ECB deposit rate falling to 3% by year-end in Feb. Whether the ECB will cut four or five times by year-end will have profound consequences on how the yield curve is going to steepen. A slow-cutting cycle might encourage the yield curve to "twist-steepen," with the short-end dropping and the long-end rising.

12_02_2024_AS1

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