Peripheral sovereigns and the hunt for yield
Fixed Income Strategist, Saxo Bank Group
Summary: The ECB's dovish pivot is supportive of European sovereigns, but the names in this space differ broadly in terms of yield and risk.
Last week’s dovish performance was unlikely to sway this theory’s believers; after all, Draghi’s native country is in a recession and removing the ECB monetary support that has benefitted Italy for so long would mean placing further pressure on an economy that is already struggling.
We do not believe, however, that Draghi is coming to rescue Italy; rather, he’s intervening to save the European Union from an emerging crisis. After all, it’s not just the periphery, or Italy, that’s in trouble. Europe is in bad shape as a whole, and even the German economy is starting to show signs of fatigue.
It is very hard to make investment decisions in the contemporary European space. Equities look a little bit too rich at the moment and the corporate bond space has also rallied significantly since the beginning of the year, eroding a lot of already-low yields. Although some investment grade corporate bonds may receive a final push thanks to dovish central bank sentiment, the safest area at the moment, and where we can see valuations supported for the long term and as the latest economic cycle turns into a recession, is in sovereigns.
Following the ECB meeting, we have seen a pronounced rally in a majority of European sovereigns. In one day, the German bund halved its yield from 12 basis points to 6 bps, a level not seen since 2016. It is obvious that the bund is positioned for more gains as the European economic slowdown deepens, and we might see the yield hit 0% as soon as this month as sovereign supply is stalling and the macroeconomic environment is not supportive with more uncertainties arising around Brexit.
Although valuations will be supported, we must ask if is it worth being invested in these sovereigns when the cost of trading could offset the yearly return? Probably not, but for investors with higher risk appetite, it might be worthwhile to consider trading Euro-Bund futures, which are very liquid and are offered on the Saxo platform.
Sovereigns from the so-called ‘periphery’ posted the most forceful rallies as the ECB outlined the details of its TLTRO program. Italian BTPs gained the most with yields falling by 12 bps during the day, closing at 2.46%. Spain and Portugal followed suit, closing at 1.04% and 1.33% respectively on Thursday. It is clear that a supportive ECB is particularly beneficial for these countries, but which asset offers the best opportunities for investors?
Spanish bonos are receiving a lot of interest from real money. As reported by Bloomberg, Japanese pension funds have been increasing their holdings in these sovereigns amid the uncertainties ahead of the April 28 elections. The market seems confident that the vote will provide little more than momentary noise, and that the focus will quickly return to the country’s economy. The Spanish economy is well diversified and the banking sector is emerging from a successful restructuring that makes it less susceptible to systematic risk. It is easy to see why Spanish sovereigns appeal to Japanese real money as Japan struggles with negative interest rates, but other investors might find the 1% yield insufficient, especially those dealing with higher funding costs.
This is why Greek and Italian sovereigns again steal the show. With Italian 10-year BTPs offering approximately 2.55% in yield and Greek 10 -year sovereigns offering 3.7%, it is near-impossible to find higher-rated corporates that offer that kind of yield.
It is possible to find yields above 3% in the high yield space when looking at subordinated financials of smaller regional bank. The subordinated bond of the Spanish Banco Sabadell with coupon 5.375% and maturity December 2028 (XS1918887156), for example, offers a yield of 4.9%. Italy’s UBI Banca has a subordinated bond offering a coupon of 4.45% and with maturity September 2027 (XS1580469895) paying 4.6% in yield, but the risk concentrated in these names is extremely high and we believe that as the EU economy stalls alongside continued low interest rates, European banks are going to experience difficulties and their subordinated bonds will be put under considerable stress.
Looking at some more conservative high yield names, we see that yields are much lower. For example, Spanish multinational pharma and chemical company Grifols’ bond with maturity January 2025 and a coupon of 3.2% (XS1598757760) yields only 2.8%; turning to emerging markets, we see Brazil’s Petrobras with maturity January 2025 and a 4.75% coupon (XS0982711714) offering a yield of 2.8%. Similarly, Cemex with maturity December 2024 and coupon 2.75% (XS1731106347) is offering a yield of 2.7%.
In this context, a sovereign bond issued by the fourth-largest EU economy offering a yield of 2.6% for 10-year maturities clearly offers the extra pick-up that yield-starved investors in the European area are looking for. It is true that the higher yield reflects political and economic challenges, but as long as the ECB doesn’t start to tighten, peripheral sovereigns will be supported.
A note of caution, however: this might not be true for Greek sovereigns. While Italian BTPs are supported by demand from domestic investors, Greek government bonds are held mainly by foreign investors, meaning that as soon there are concerns over the European and global economy, there is the risk that these funds will fly home toward safer products, causing Greek bonds to fall.
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