Euro-zone sovereign bonds: A parallel world
Thereare few simple answers when regulation and demographics are pushing investors into fixed income assets at a time when yields are ultra low or neg ative. Asset managers are increasingly in demand for portfolio advice as they seek to navigate this topsy-turvy world.
“Our duty is not only to manage our own portfolios but also to advise our clients,” says Patrick Barbe, chief investment officer of euro sovereign and aggregate at BNP Paribas Investment Partners (BNPIP). “The question they are asking is where can they invest their cash, given such low government bond yields.”
The answer is tricky. Potential investors in Europe’s sovereign bond markets could be forgiven for thinking they have stepped into the Mad Hatter’s tea party in Alice in Wonderland. In effect they are paying for the privilege of investing in debt.
This reality is hard for investors to swallow. “If you have negative yields in the long part of the yield curve it turns on its head all the traditional arguments about the time preference of money,” says Gareth Colesmith, senior portfolio manager at Insight Investment. “Who would be prepared to defer spending today in order to get less spending in the future?”
German Bund yields were negative right up to a maturity of eight years in mid-April, while other euro-zone bond yields were negative out to five years. Yields in Denmark and Switzerland, both outside the euro-zone, were also negative, and in April Switzerland became the first European government issuer to auction benchmark bonds at a negative yield, of -0.555%, and a Danish sex therapist was able to take out a three-year loan at a negative rate from Realkredit Danmark, a property financing company, according to the Financial Times.
“Should 10-year German bunds be trading at a yield of 10 basis points or less when Germany is expected to grow in 2016 at 1.8% a year with 1.6% inflation [as forecast by Bloomberg]?” asks Iain Stealey, head of global aggregate strategies at JP Morgan Asset Management. “The answer to that is clearly no.”
Europe is suffering from two powerful but opposing forces that reflect the chaotic responses to the global financial crisis. The implementation of quantitative easing (QE) by the European Central Bank (ECB) aims to suppress yields across the curve with the explicit target of increasing investment in the riskier areas of the corporate sector in an effort to stimulate the European economy. “This has been long overdue and should have happened years ago alongside the US Fed and the Bank of England. Europe is now putting its house in order, and even the German Bundesbank, even though it was not in favour of QE, will see it through,” says Stealey.
At a glance
• Core euro-zone government bond yields have continued to fall to record low levels or are negative.
• There is a difference of opinion on whether bonds are in bubble territory, although some of the conditions for a bubble seem to have been met.
• Pension funds have benefited from the hedging effect as lower bond yields have helped protect them against higher liabilities.
• There has been increasing interest in the periphery.
Supply and demand
However, as Marie-Anne Allier, head of euro fixed income at Amundi, points out, the implementation of capital adequacy rules for institutional investors – through Solvency II for the insurance sector and Basel III for the European banking sector – has the explicit goal of assigning often punitive capital requirements for investing in riskier assets than government bonds. The effect is to force banks and insurance companies to maintain or increase holdings in risk-free government debt no matter what the yield.
Pension funds with a focus on solvency are also encouraged to hedge out their surplus or deficit volatility through matching liabilities with government bonds, irrespective of yields, meaning the euro-zone’s regulatory regime and its economic strategy are essentially pursuing conflicting objectives. Partly as a result, bond yields have increasingly turned negative in many of the region’s key sovereign debt markets.
“The biggest bubble may be in the use of the term ‘bubble’ rather than in financial markets”
Valentijn van Nieuwenhuijzen
“I would suggest there is a bond bubble,” says Insight’s Colesmith, who sees two factors driving bond markets into frothy territory. First, the negative deposit rates imposed by the ECB. He says: “If you are a holder of cash, then you would be looking to a more attractive option than bank deposits and that may mean higher yields through investing in bonds, even if they are still negative.” Second, the nature of QE in the euro-zone is different from that already seen in the US, UK and Japan.
In the UK, for example, the Bank of England has bought net new issuance of bonds, enabling other investors to keep their exposure to UK sovereign debt unchanged if they wish. In contrast, in Germany, the net supply of government debt is zero but the ECB is still a large buyer and the amount of bonds the ECB is set to purchase is larger than the supply available. If euro-zone investors want to maintain exposures to sovereign debt, the size of the free float available is shrinking. “There are also technical factors such as the fact that the ECB will not buy bonds yielding lower than the deposit rate of minus 20 basis points, and there is an increasing proportion of German bonds that yield less than that. So they concentrate their buying on bonds that yield more, which drives their yields downward,” says Colesmith.
Arguments over the possible existence of a bond bubble are still raging. Valentijn van Nieuwenhuijzen, head of multi-asset at NN Investment Partners, formerly ING Investment Management, is not convinced there is a bubble: “I struggle with the label. The biggest bubble may be in the use of the term ‘bubble’ rather than in financial markets.” As he points out, many criteria need to be met for a financial bubble to exist.
For a start, there needs to be a misalignment between valuations and fundamentals: “Outside QE, if you assume yield curves are just predicting future estimates of overnight rates, is it unrealistic to assume that the ECB will keep overnight rates at around zero for the next five years?” Whether the European bond market as a whole is completely misaligned with fundamentals is an open question and Van Nieuwenhuizen says there is certainly not a bubble in global bond markets given the steepness of the yield curves.
NN Investment Partners’ head of multi-asset does not see QE as fundamentally different from other forms of monetary easing. It is an extension of the role central banks are always playing and the ECB’s extraordinary measures are for understandable reasons: “[The ECB] has been undershooting its inflation targets for more than five years. It sees a large output gap and a weak level of activity in the euro-zone economy. It has also experienced a huge undershoot of inflation compared with both expectations and its own models over the last 12 months, and an erosion in the stability of inflation expectations. If that is the fundamental backdrop, a significant policy easing is to be expected so it is not out of synch with fundamentals.”
The final argument against the existence of a bond bubble, according to Van Nieuwenhuizen, is that the label implies the market will suffer a dramatic sell-off soon. “The probability of that happening is not high given QE and the financial repression we are seeing,” he says. Amundi’s Allier agrees: “We don’t see the situation as a bond bubble because when you refer to a bubble, you believe it will collapse dramatically. We see the regulatory environment and the existence of QE as preventing a large rise in bond yields generally, although German bond yields are so low that they could see an increase.”
Colesmith takes a different view. “By September 2016 the ECB will have stopped QE so at that point at the latest, the market should revert to pricing fundamentals,” he says. “At some stage before then the market should realise the economy is doing fine and the ECB buying will not go on forever. You may as well sell now whilst the ECB is buying and at that stage yields could go materially higher.”
Barbe also points out that central banks around the world are among the main holders of euro-zone sovereign debt. “A large share is held by central banks in Asia, the Middle East and South America,” he points out. “There is no risk of inflation anywhere globally so if there are higher yields in US Treasuries or UK Gilts, I cannot imagine Chinese and Japanese central banks maintaining large exposure to euro-zone sovereign debt. So in short and medium term maturity debt that was bought by banks in the past, the ECB impact is huge, whilst for longer maturities there is still a risk of outflows from institutional investors.”
As Colesmith points out, bond yields have risen sharply in several other environments, such as the emerging market taper tantrum in 2013, as well as a couple of instances in the Japanese government bond market. “We are probably going to get a situation like that in the euro-zone in the next 18 months and there is a chance it could happen sooner,” he warns.
Despite the negative yields, there is still some demand from pension funds. As Anthony Gould, the head of global pensions at JP Morgan Asset Management, points out, many are looking at bonds in general as a way to get interest rate exposure to match liabilities. While euro-zone government bonds may not provide meaningful yields they still provide a hedge against interest rate moves. “A pension fund may be asking why it would want to invest in a seven-year Bund with a negative yield,” says Gould. “But if interest rates keep going down the value of their liabilities will be increasing. The headline level of yields does not matter, but rather the direction they are heading.”
Other funds where the funded status is better, and a larger proportion of liabilities has been hedged, have an incentive with negative yields to take more risk. The expectation is that over time the value of their liabilities will decline in a negative-yield environment.
In aggregate, Gould believes flows around the world show that pension funds are continuing to be net buyers of fixed income. He says: “But for years and years now, pension funds have been selling equities and buying fixed income. This year we may see the opposite as the growth environment in Europe has improved and we are seeing the eighth year of recovery in the US.”
Persistently low and negative yields will eventually give rise to serious problems for many institutional investors, particularly those insurers and pension funds operating under insurance legislation in many parts of Europe that have to meet fixed yield guarantees.
“When we talk to Nordic pension funds, they are very upset. If they can invest only at 1% but have to pay out 3% to their beneficiaries it creates tensions,” says Amundi’s Allier. As she points out, in many countries mandatory client yields do not necessarily reflect current market levels: “In France there is a new yield set each year, which is a function of market yield. But in the Netherlands and Germany, for example, the yield set at the start of a contract can be there for the full life.”
She adds: “This was also the case in Japan as well until it resolved the problems with a new law that meant that yields would be revised on a yearly basis. Even in France the retail savings accounts may pay 1%, which is higher than they can get by investing new flows in the market. They can continue like this for a few years at most. Hopefully the economy will grow and inflation will rise along with bond yields, so we enter a virtuous cycle.”
If the current environment persists indefinitely and the ECB does nothing there will be a solvency problem arising for many institutions across Europe, according to Allier. “That is a long-term issue but if it ever arises it will be a much bigger problem than one, two or three years of low and negative yields”.
The lure of the periphery
Clearly, institutional investors are reacting to the low and negative euro-zone sovereign debt yields in different ways according to the risk appetite and constraints of their clients. Moving back into peripheral euro-zone debt has been a natural reaction for many, especially since ECB President Mario Draghi’s 2012 pledge to do whatever it takes to save the euro-zone led to a new regime for investors in the periphery. As a result it has become a viable alternative; depending on their geographical location, many investors had pulled away from peripheral debt prior to that to focus on ‘core’ euro-zone debt.
Allier says Amundi is largely invested in peripheral versus core and longer maturities rather than shorter. “We are overweight Italy, Portugal, Ireland and Slovenia at the expense of Germany, France, Belgium, the Netherlands and Austria,” she says. Deciding on relative value can be a challenge, according to van Nieuwenhuijzen, who says NN Investment Partners is agnostic on valuations but tries to assess the direction of change in the peripheral bond markets. On that basis, he is positive on all the peripheral markets with the exception, like almost everyone else, of Greece.
Barbe says BNPIP does not advise his clients to go outside the euro-zone because although yields are low, risks are also low. His firm’s response has been to move to longer maturities to catch return and invest outside the maturities affected by QE: “In the past, the average global yield was about 4.5%. Now it is 2.5%. To have a risk-free bond at around zero is odd but taking inflation into account presents a clearer picture. Real yields today are similar to what they were a year ago but what has changed is the inflation forecasts. Inflation will be low for an indeterminate period, according to almost all economists. On this basis, negative nominal yields today give real yields equivalent to what they were in 2013 if we take account of the changes in inflationary expectations.”
For European investors the real problem is that there are not enough alternatives to the shrinking sovereign debt markets. “There is much talk about increased corporate lending, infrastructure debt and so on but you are not going to find €1trn of loans,” says Barbe.
A move to credit, as well as to the periphery, is the result. “More and more pension funds are also moving into real estate, illiquid assets and the like,” notes Allier. “The regulatory burdens arising from capital adequacy rules means that equities are still under pressure though, but they are trying to fund higher yields than seen in the sovereign debt markets
To that extent, the ECB’s QE strategy is having an impact, albeit heavily muted by the opposing forces of regulatory capital requirements. But having the ECB and the regulatory environment both pushing bond yields lower has brought the bond markets into Alice in Wonderland territory. “Is it an efficient way of proceeding? We do not think so,” says Allier. The debate about whether it is leading to a bond bubble is likely to run.
Perhaps van Nieuwenhuijzen’s view is most apt when he returns to the topic of a bubble: “The answer to the question of whether we are seeing a bond market bubble is a yes with nuances for the German Bund market and a no for most other bond markets.”
But while many can make arguments for continuing to invest in bonds despite negative yields for their institutional clients no-one is likely to invest their personal wealth for their grandchildren on that basis.