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European Bonds: Down But Not Out

In the wake of Europe’s sovereign debt crisis, investors have abandoned European bonds in droves, creating opportunities for active managers. Strategies include the intelligent use of credit default swaps to mitigate losses or even produce gains.

When it comes to European sovereign debt, professional bond investors seem to have taken fright, reducing or eliminating all such exposure from their portfolios. But are there opportunities to be found beneath the gloom-ridden headlines and talk of default and recession? The euro zone is in a bind. Greece, Ireland and Portugal have all been forced to seek shelter under a rescue umbrella that is effectively lead-financed by Germany. And that umbrella comes with a hook: austerity measures that require a whole lot of belt-tightening. These measures may make growth elusive in the short term — and it is exactly that growth that is ultimately most likely to resolve the debt overhang. Spain is the latest country in the crosshairs. Its ten-year bond yields have recently risen above 6 percent, an unsustainable level for the long term but one we saw not so long ago, both in Spain and in Italy. The European Central Bank has provided temporary relief by pumping €1 trillion ($1.3 trillion) into banks — a move that may actually exacerbate bank losses unless government bond yields decline once more. The pressure is on governments to cleanse their local banking balance sheets yet increase lending, rein in spending, foster growth and promote job creation while making major supply-side employment reform. These are daunting and potentially conflicting tasks that are only likely to work if the rest of the euro zone gives its unequivocal and unlimited support for as long as it takes. This level of support has been lacking to date, and recent elections have not engendered helpful sound bites. But poetic election promises are often starkly different from the cold reality of government prose. A breakup of the euro would undoubtedly be costly in the early years. The cross-holdings of most government bond markets mean that the impact of devaluation and default is extremely difficult to predict compared with the known downside of further support. Bad news and trouble cause dislocations in markets — at which point buying the underowned, oversold bond that does not then default has proved to be a better choice than chasing the overowned and overbought alternative. The exit of so many bond investors from peripheral European countries has created latent buying power. For sovereign wealth funds in particular, strategic cooperations — combining the purchase of bonds with preferential access to infrastructure such as ports and airports — may be possible. Income-focused investors will be lured by higher coupons and higher yields. In a world where Germany’s ten-year debt yields less than 1.5 percent despite being deeply intertwined with the finances of the country’s less robust neighbors through the Target2 cash transfer system, a yield of 6 percent or more could be attractive to such investors. After a 30-year bull market in government bonds, flexibility is the order of the day. Being a long-only, passive investor has become a dangerous approach in a period of roller-coaster yields. Protection is occasionally vital. The first quarter saw yields rise, so interest rate protection would have been helpful. In April, European credit spreads widened; buying credit default protection via swaps is now mainstream, and for good reason. Actual defaults in developed, high-grade markets have been rare for several decades, and it is all too easy to extrapolate the good fortunes of the past into the future. The ability to protect customers’ capital for not much cost — from the remote but real risk of a catastrophic loss (Greece) or just credit spread expansion (France) — should be a core requirement for investors. The political rhetoric ahead of the presidential elections has weighed on French bond prices. Despite being seen as pro-Europe, François Hollande has been quite vocal about reneging on the Stability Pact and France’s contribution to it. In this scenario the intelligent use of credit default swaps could mitigate losses or even produce outright gains. An equally promising investment comes in the form of “orphan” bonds, which are sovereign bonds denominated in a foreign currency — for example, a bond of a Spanish issuer denominated in Australian dollars. Spanish investors prefer the euro version, while Australian investors shy away from an investment in a faraway issuer. Consequently, these bonds are trading at deep discounts, with admittedly limited liquidity, and are extremely appealing for investors with the ability to hold them to maturity.  The list of “things that can go wrong” this year remains long and worrisome. The outcomes could create seismic moves in capital markets. Yet the key determinant of options to protect against some of these moves — implied volatility — remains remarkably cheap.

Active, not passive, investment, with a modern protection strategy, would seem to be the smart approach for the next decade.  •  •

Tim Haywood is investment director for fixed income at London-based GAM, which manages $48 billion in assets.

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