Head - Fixed Income Strategy
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Having made a small loss this year, European sovereign bonds could face further pressure.
Long-dated euro yields have generally moved higher this year, though remain bound by negative interest rate policies, ongoing quantitative easing and an unpersuasive push in Eurozone (EZ) inflation. Indeed, 10-year German Bund yields had nearly touched 50bp twice since January, only to eventually decline back down towards the lows of the year. On the other hand, short euro rates remain well anchored. Even in political hotbeds like France and Italy, 2-year sovereign bond yields remain well entrenched in negative territory. Still, as a whole, Eurozone sovereigns have returned -1.0% this year.
For global investors, we remain underweight euro rates. In our view, relatively more attractive yield opportunities exist in other parts of the world. Even for regional investors, increasing expectations of further ECB bond tapering could have downward pressure on bond prices. Indeed, starting in April, the ECB will begin reducing the size of their monthly asset purchases to €60 billion, from €80 billion. We expect more tapering to be announced toward the end of the year, as the ECB confronts supply constraints in several EZ countries.
Markets may also need to contend with the possibility of an ECB rate hike later this year. A significant change in ECB messaging in March was the reference to a possible rate rise even before tapering ends. While market expectations for a rate hike remain quite low, if combined with additional tapering, both could pressure yields higher.
All eyes will be on the first round of the French election on April 23. Our view remains that while populist candidate Marine Le Pen could win in April, she would likely lose in round two on May 7. Still, despite the low probability of victory, markets remain underpriced for a political surprise. On the other hand, if elections play out as the polls suggest, it’s also likely we’ll see 10-year French sovereign spreads (to German Bunds) tighten back toward 40-50bp (currently 65bp).
In the periphery, the lone outlier in performance has been Portugal. While Spain, Italy and Ireland have all produced negative returns this year, Portugal has managed to gain +1.5%. This is likely to be a result of already cheaper valuations, and the lack of any negative attention. Indeed, much more has been made about Italian politics, debt sustainability and euro membership. In our view, periphery yields are likely to remain volatile. That said, a positive outcome in French elections and continued fundamental improvement in the EZ could push Portuguese sovereign spreads tighter, fueling further outperformance.
In the UK, Prime Minister Theresa May as expected announced the triggering of Article 50 of the Lisbon Treaty on March 29. This begins the 2-year clock toward the UK’s departure from the European Union (EU). Unsurprising to us, Gilt yields continue to rally. In our view, future negotiations with the EU are unlikely to be easy for the UK and the economy is already showing some signs of weakness. More important, the increase in market uncertainty will continue to fuel safe haven sentiment and the demand for Gilts.
We maintain our neutral duration view, despite some improvements in the projected future net issuance of Gilts. Overfunding in the 2016-2017 fiscal year could allow the Bank of England to carry forward funds and reduce issuance for 2017-2018. While this is supportive for Gilt yields, we note that the Bank of England has also concluded buying Gilts in their latest QE program. That said, inflation linkers still appear to be the better investment option. Or at least as a hedge against any inflation pass-through from renewed sterling weakness.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.