Duration bets are impossible, carry can be very volatile and fixed income correlations have shot up. Martin Steward finds life getting tricky for even the best active European bond managers.

It’s tough at the top of a multi-decade bull market, and tougher still when the might of the world’s major central banks is determined to prolong it. With central banks anchoring short-end rates for the foreseeable future, duration risk has been much more sensitive to statements from the likes of Angela Merkel, Nicolas Sarkozy or Antonios Samaras than to macroeconomic fundamentals.

“We have a duration overlay strategy where we take short-term positions,” says Sandor Steverink, head of rates at Delta Lloyd Asset Management. “Usually that adds 50 basis points or so to annual performance, but for the past 12-18 months we haven’t been able to add any value with it.”

From its three alpha sources of duration, curve and country positions Aegon Asset Management has found it “very difficult to add value using duration trades”, confirms its head of rates, Gerard Moerman.

“It remains difficult because central banks have been very clear that they won’t hike rates any time soon, and yet markets are pricing-in a turnaround in global economic expectations,” he adds.


As a result, these strategists, as well as our third featured this month, Pictet Asset Management, are sticking pretty tight to their respective benchmarks where interest rate risk is concerned. There is one consolation – sustained steep yield curves offer the prospect of sizeable carry, and that is where these strategists’ are spending most of their non-credit risk budget.

Moerman points to Japan as the classic playbook. Rates and curves moved about significantly enough during its bond bull market, he observes, but a simple overweight at 5-10 years versus 0-5 years outperformed considerably, thanks to the roll-down. The 7-10 year bucket annualised close to 4% since 2000, double the available yield.

“That shows how powerful the roll-down can be,” he concludes. “Some European forward rates are pretty high, which is why we like the 2019-22 paper in a lot of countries, and the 2017-19 paper in peripherals.”

Delta Lloyd has been doing the same in the non-sovereign sectors, where it has more leeway to play than Aegon.

“Our view is that Draghi will keep policy rates low, and in that environment carry and roll-down is key,” says Steverink. “Looking at things in those terms you see that the short end of the curve offers very little value and around the 10-year segment there is more carry.”

Carry positions can leave managers exposed if yields rise more than had been priced-into curves, leading to nasty mark-to-market losses in what are essentially bear-flatteners. These impressive longer-term performers have suffered during the course of 2013 partly because markets have pressed ahead with rate ‘normalisation’ far quicker than central banks envisaged. But, for now, they are sticking to their guns.

“The question we are currently struggling with is the extent to which rates can rise while economic growth remains very low and lending standards are tightening,” says Moerman.

“Headline inflation in Europe is 1.3%, but strip out all the VAT hikes and you find yourself much closer to zero and, in some cases like Spain, even below zero. Decreasing wages in the periphery and rising unemployment in core countries like the Netherlands will keep this deflationary pressure in place for a while. We need to see a bit more evidence of real recovery before we think rates can go up much further at the long end.”

Andres Sanchez Balcazar, co-head of global and regional bonds at Pictet, also expects the ECB to inject more liquidity – particularly as monetary conditions have tightened as banks that never really needed its LTRO facility in the first place have been quick to pay it back.

“Just look at the strength of the euro recently, which shows that the market regards the ECB as overly tight,” he says. “The same kind of thing happened in 2011, when the euro was strong for all the wrong reasons – banks withdrawing capital from emerging markets to plug their own liquidity gaps. That is not consensus because most people have their eye on the growth data, which has been fairly supportive recently.”


If all three managers basically share positioning with regard to duration and curve at the moment, the same cannot be said for country and credit risks.

In country terms, the core-versus-periphery debate dominates, unsurprisingly. In the core itself, chief interest lies in positioning among those countries considered the weaker credits, or even ‘semi-core’. 

Dutch government bonds account for just 5% of Aegon’s portfolio. Moerman acknowledges the AAA rating from all three major agencies but points to the risks that are leading to a widening spread over Germany.

“In the short run I’m not so worried about that, but politicians really do need to make a stand and show that they are getting to grips with the economic situation,” he says. “We have been taking profits.”

His compatriots at Delta Lloyd have been doing the same, going from 11% to a benchmark-neutral 5% over the summer.

“Short term, things don’t look great – politicians are more concerned with arguing amongst themselves than doing the best thing for the economy,” laments Steverink. “But looking through the political cycle you can still see that the Dutch mentality remains very sensitive to the financial situation and the reality of paying back debt. So we don’t see any default risk in the Netherlands, but as it is AAA, upgrade is impossible, whereas short-term difficulties might well result in a downgrade.”

One of Aegon’s most successful bets from the past 12-18 months has been an overweight to Belgium, another of those ‘semi-core’ names that worried investors before the ECB’s OMT announcements last year, and whose rally since then has caught a good many investors off-guard.

“We are looking to take some profit there just because there is some political risk ahead of us in 2014 and the position has tightened a lot,” says Moerman. “Currently it has issues with higher debt, but the primary deficit is closing and there are much greater growth prospects [than in France, for example]. Belgium was 50-60 basis points over France but, in our view, it is a much better credit.”

As Moerman’s words suggest, wariness with the Netherlands and diversity of opinion over Belgium turns to outright dislike with France. Delta Lloyd’s 4-5% position is in quasi-sovereign paper secured against infrastructure – it holds no government debt.

“We are very negative on the fundamentals of France – even the AA rating is too high, in our view,” warns Steverink.

“We think that France is clearly the weakest core country,” agrees Moerman. He puts the government’s bonds at around fair value, but worries that France is almost culturally blind to its unemployment problem and large social security and healthcare liability.

“Everyone can do more with reforms, but whereas Spain is doing quite a lot, France is doing very little,” he reasons. “If Spain continues with its reforms it is really sowing the seeds to profit from the much better economic environment that’s around the corner.”


This statement hints at the extent to which Aegon’s strategy is seeking its yield from Europe’s periphery. Italy is its biggest regional position at almost 25% of the portfolio (almost three times the size of the allocation to Germany) and its biggest single position (12.7% in the government’s 2017 bond). Spain comes in third, behind the UK, at 10% of the portfolio – again, focused on 2017 paper.

The curve positioning is about maximising carry, but also about managing the credit risk-return pay-off.

“The total portfolio is positioned so that the riskier the country is in terms of credit, the shorter the maturity we hold,” Moermans explains. “If things go wrong in Italy, then that will be felt much harder at the longer end, partly because that part of the curve doesn’t benefit so much from OMT optionality. That’s why the curves of these countries are really flat after the 6 to 7-year point, but the spread is so much higher at the longer maturities. It’s also because it’s easier to see what’s going to happen in the coming 2-3 years than over the next 10-15 years, and while in 15 years Germany, the UK, the Netherlands and the core countries will still be solid, even after a downgrade or two, the peripheral countries have much nearer-term risks.”

While Pictet is not underweight Spain (where Sanchez Balcazar gives credit for improving unit labour costs), he is underweight France and Italy (for lagging on that measure). He reiterates what he perceives as the danger posed to the periphery by a liquidity squeeze (from both repayment of LTRO and Fed ‘tapering’), but adds a list of potholes for the rest of this year that could still bump the euro-zone show off the road.

“There is the German election; the publication of bank stress tests that will show big exposures to their respective sovereigns, especially in Italy; the renegotiation of the Portuguese bail-out package, with the potential for haircuts,” he says. “None of the problems affecting the euro-zone a year ago have magically disappeared. Draghi’s ‘whatever it takes’ promise has never really been tested. In short, we think that being underweight France and Italy is not bad as a macro-systemic hedge. We are very value based, so as long as peripheral yields don’t compensate us for the risk we just won’t take the position. I can always explain that to my client – even if, as happened recently, Italian spreads do phenomenally well.”

Steverink tells much the same story at Delta Llloyd, whose underperformance this year has come from eschewing the periphery.

“The underweight to Italy is the biggest active position and the one that caused us the most pain,” he says. “But we still cannot exclude default risk in those countries.”

Like Sanchez Balcazar, the Delta Lloyd managers point to the importance – but also the fragility – of the OMT undertaking.

“If I compare the experience in peripheral sovereigns with my own in corporates, I’d observe that we were a big buyer of financials, for example, in 2008-09, when yields went up to anything from 12% to 25%,” says head of credit Arnold Gast. “This never happened in the major sovereign bond markets: as soon as they approached 7% the ECB and the politicians stepped in.”

Steverink concedes that he has been too fundamentals-focused.

“While fundamentals should count for something in the long run, this central bank behaviour just keeps postponing it again and again,” he reflects. “We’ve had some very difficult discussions about how we position ourselves there: do you continue to assess countries fundamentally as standalone credits, in which case you have to conclude that you will come to restructuring events; or do you try and factor-in the help they can receive from other countries and agencies, and the market sentiment around that? We have become a little more humble and responsive in the face of central bank policy and sentiment-driven flows, and have to concede that we completely underestimated the impact of Mario Draghi’s words last year.”


Even though the AEGON strategy is the only one reviewed here that confines itself to sovereigns and quasi-sovereigns (and is currently more than 98% allocated to governments bonds), this split in regional exposure means that it has the highest portfolio yield, at 2.71%, and the raciest credit-rating exposure, with 40% in BBB bonds.

This offers some indication of the relative conservatism of the positions that Delta Lloyd and Pictet take outside the sovereign universe to balance their focus on the core euro-zone.

Delta Lloyd talks up the flexibility it enjoys to allocate to markets like Slovakia, the Czech Republic and Poland, which have performed well for it over recent months. But more important is its 30% allocation to corporate bonds and collateralised securities. 

“Especially in the sovereign sector, we do not take much risk,” says Gast. “So in the corporate sector we take a little more risk, so that the total risk profile of the fund is quite close to the benchmark.”

In non-financial corporates the firm has favoured defensive consumer goods and utilities names at the longer end of the curve. In financials, short duration and call dates are preferred, with subordinated lower tier-2-style paper having performed well for the fund.

Alongside that, the strategy has gone for covered bonds, or preferably RMBS, leaving out senior unsecured because of the increased subordination risk it faces. This bank capital structure barbell has been one of the key trades for bond managers in financial paper over the past 12 months.

That balanced-risk approach – tied with the fact that Delta Lloyd favours banks in Switzerland, the UK and the US – helps explain why portfolio yield sits at just 2.15% and only 17% of assets are in paper rated BBB or lower.

Pictet, yielding just 2.06%, holds 33% of its portfolio in BBB, but that is concentrated in higher-quality assets and there is nothing in lower-rated segments. Most of its non-sovereign exposure is in covered bonds: Sanchez Balcazar makes the same point as Delta Lloyd about subordination and bail-in risk in senior unsecured bank paper – “a huge area of uncertainty in Europe, now” – but does not implement the higher-yielding lower tier-2 element of the barbell trade. 

“We look for a bit of extra spread that can withstand the kinds of shock that we anticipate for the euro-zone later in the year,” he reasons. “That means giving up some potential spread – particularly against something like Italian bonds, for example – and therefore running less yield than the benchmark.”

But this touches on an important point that helps explain why all three of these strategists have had a hard time this year, despite significantly divergent positioning – the lack of diversification available in their markets.

Sanchez Balcazar emphasises the importance of risk budgeting for a strategy like his, which considers itself long-termist and contrarian and has to be able to live with the volatility of its positions. He is especially careful to increase risk only if he is confident that he can diversify it.

“The real shock this year was the correlations across all parts of the market – everything sold-off in fixed income in May and June,” he says. “A lot of people just decided that the Fed was wrong and moved heavily into credit, despite spreads remaining fairly tight. But we accept that there has been a shift, that we got the Fed and our expectations about correlations wrong. Our response has been to reduce risk across all sectors and alpha generators of rates, spreads and FX.”

But reducing risk means heading for carry positions and the core government bonds that dominate the Pictet and Delta Lloyd portfolios – positions that provide little mark-to-market shelter when markets are hoarding liquidity and forcing up yields (figure 1). Active management is a thankless pursuit in these conditions.

“There are very few areas in fixed income where you are being paid well at the moment, outside of some of the short-rates and high-yield,” Sanchex Balcazar concedes, somewhat wearily.

Or, to put it another way, it’s tough at the top of a multi-decade bull market.