When government bond prices are volatile, it makes sense to focus on securities whose yields can offset any capital downside.
How’s European QE Holding Up?
Developments in Greece clearly represent a step into uncharted territory, with unpredictable consequences. But Europe’s policymakers have weapons in their armory that should help to prevent short-term volatility from spiraling out of control.
One of the most important is the European Central Bank (ECB)’s quantitative easing (QE) program. It serves as a crucial backstop for regional bond markets. The ECB can calibrate QE bond-buying to address turbulence, for example, by adjusting the speed and the composition of purchases when trouble spots arise.
So far, experience of ECB-style QE suggests that it’s having an outsized impact on regional bond markets. That’s partly because the ECB’s monthly bond purchase quota (some €60 billion of mainly government bonds) represent such a big proportion of the total regional bond supply.
The QE effect in Europe has been further intensified because so much of the region’s debt was trading at super-low yields when the program was first announced back in January. Indeed, the rush of ECB money had driven yields on nearly 30% of Europe’s sovereign debt into negative territory by April.
Buyers of bonds with negligible or negative yields benefit only if they manage to sell them later at even higher prices. With QE scheduled to run through September 2016, investors seemed to be concluding that European bond prices could move in one direction only: higher. But evidence of slightly better economic data later prompted speculation that the ECB might rein in QE. And investors got unsettled by signs that bonds they’d bought specifically because they were scarce seemed more abundant than expected.
Together, these developments had sent regional bond markets into a tailspin by May. German bund yields surged, bond prices fell, spreads on peripheral debt widened significantly, and the euro bounced back from multiyear lows.
Caught in Crowded Trades
Did this mean investors had reassessed their medium-term expectations for European fixed-income markets? Not necessarily.
Instead, we think the sell-off quickly gained momentum because investors were holding similar bonds to benefit from QE-driven dynamics. This resulted in crowded trades offering little room for maneuver as sentiment changed, particularly since liquidity is lacking in large swathes of Europe’s bond markets. When numerous investors simultaneously looked for an exit in challenging market conditions, the sell-off accelerated. Months of price gains were wiped out in days.
Looming Bond Drought
Even without the uncertainties stemming from recent developments in Greece, we’d been expecting that rising prices and falling yields would return this year. That’s because the impact of ECB buying is going to get an extra kick when fewer bonds become available to buy each month.
The plunge in regional bond yields when QE began encouraged many governments to take advantage of this ultra-cheap borrowing opportunity, by frontloading issuance in the first half of the year. Ireland, for example, had completed about 70% of its full-year bond issuance by May. This busy issuance calendar has, so far, provided enough bonds for the ECB to meet its QE quota each month.
But supplies could start to dry up as the year progresses. In fact, the net supply of European sovereign bonds looks set to turn negative in the next six months because total bond redemptions will exceed expected new issuance. This bond drought can be expected to turbocharge the impact of ECB buying on prices, forcing a comeback of low-to-negative yields, spread compression across the euro area’s 19 bond markets and a general flattening of yield curves.
Remember the flash spike in US Treasury prices last October? That was driven by an unanticipated turn in investor risk appetite, which had a huge impact on prices because several big market players changed course together. It shows that even the world’s biggest government bond market can’t escape extreme price volatility when many investors jump on the bandwagon at the same time.
Bucking the European Bond Trend
What can investors do? Start by moving away from the crowd. In particular, we think the recent widening in peripheral spreads and move higher in core European government bond yields has opened up attractive buying opportunities in higher-yielding longer-duration bonds.
Yield curves in Italy and Spain are relatively steep, so their longer-term bonds offer a nice yield pickup—30-year Italian and Spanish debt is yielding around 3.25%, compared with the less generous 1.25% on offer from their countries’ five-year bonds. And these superior yields disappeared in the months following the ECB’s announcement that QE would start—even before the bank actually began buying these bonds.
Where are these yields now? They’re around the same level they were before QE began—or even higher in some cases.
A word of caution. We’ve seen how quickly price upside potential can be wiped out when lots of investors try to book profits on similar assets at the same time. So, instead of viewing QE as a one-way bet on rising prices, be prepared for prices to stay volatile. And think twice about government bonds whose return potential relies almost entirely on the prospect of price gains.
Instead, focus on higher-yielding assets whose income cushions offer a buffer against any hits to capital returns when turbulence strikes. Paying for the privilege of lending to governments—which is what investors are doing when they buy negative-yielding government bonds—is not a sound long-term investment strategy.
This blog was originally published in InstitutionalInvestor.com.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.