Investors are operating against a backdrop of considerable global economic uncertainty, with sentiment squeezed on one side by the slowdown in China and on the other by rising rates in the US. But although the year has started off with volatility across asset classes, investors feel the SSA sector is well supported and is healthier than it has been for some years.
Despite the early weeks of 2016 being characterised by volatility across all markets, many investors insist they are relatively upbeat. There is a feeling that the worst of the European sovereign debt crisis is over and that the root cause of the problems lay with a sickly banking sector that has been nursed back to health.
Europe’s public deficit is now largely under control, growth is picking up and, of course, the ECB has put its money where its mouth is in terms of supporting the continent.
Cosimo Marasciulo, head of government bonds at Pioneer Investments, said: “The ECB’s public sector purchase programme (PSPP) will remain the dominant topic for the SSA sector. PSPP has supported the market and more SSAs are now included in PSPP; this should continue to underpin the SSA market.”
The ECB looks set to be supportive in other ways too.
“A further cut in the deposit rate from –0.3% by the ECB looks likely this year, along with a potentially expanded QE programme,” said Ross Pepperell, partner and director of research at CheckRisk, a provider of risk research and analysis for investors. “This will pull down yields across the term structure but especially at the short end. One to three-year Triple A euro government bond yields look expensive at –0.42%.”
The longer term investment case for government bonds remains intact, added Pepperell. “Despite being distorted and overvalued, central bank policy and deflationary pressures are likely to keep them well bid over the next few years.”
All eyes on the Fed
“The future yield trends of SSAs are likely to depend to a large extent on the Fed’s decision,” said Marasciulo. If interest rates in the US rise further this year, European bond yields will follow, he predicted, though with lower momentum, with the ECB doing what it can to protect the euro bond market from any resulting turbulence.
“Probably, we will see a more gradual increase instead of an imminent spike in yields,” Marasciulo added.
However, many are proceeding with caution. While the SSA sector is attractive on fundamental grounds, given its high credit quality and stable ratings, “ultra-low absolute yields make it difficult for real money investors to purchase SSA bonds”, said Marasciulo. “Given the supply dynamic at the beginning of the year, a softer tone should prevail.”
Focus should therefore be more on relative value in the near term, looking for the best opportunities across different issuers, countries and maturities, said Marasciulo.
Relative value is a language spoken by Patrick Barbe, head of European sovereign and aggregate debt at BNP Paribas Asset Management.
“For us it’s a relative value trade, in some circumstances we may not hold the paper for more than a week,” he said. “We like medium term maturities, three to five years, depending on the country – a little longer in Germany, for example. Generally speaking, at the shorter end you have negative rates, while at the longer end you get less primary trade and the spread isn’t so good relative to the risk.”
Barbe is also increasingly interested in agency paper.
“In the period 2010–2014, the focus was on quality, meaning investing in sovereign and covered bonds. But since 2014, we have been more active in sub-sovereign credits like agencies, especially since ECB purchases have had such a positive impact on this market.”
BNPAM has replaced some of its allocation to French sovereign debt with Cades, for example, taking advantage of the higher returns and increased diversification it offers.
“The liquidity of agencies isn’t as good as for sovereigns, especially since it was included in the PSPP, but we don’t worry about that. Agency paper doesn’t attract as much speculation, so it also tends to be less volatile,” said Barbe.
“In the US and UK, sovereign yields are higher than in the eurozone, so there is less incentive to replace sovereign exposure with agencies,” he added.
Marasciulo sees more value in euro-denominated agencies with a seven to eight-year maturity than in supranationals, given supranational issuance is likely to be higher in 2016, and PSPP support for their debt could fall.
“As an alternative, after the ECB’s extension of eligible assets, there is value in German Laender,” said Marasciulo. Despite spreads tightening in mid and long-term maturities after the announcement, there is still some way to go, he said.
The relative appeal of agency and supranational paper is, of course, heavily influenced by the nature of the state guarantee offered, which is intended to preserve issuers’ access to medium-term funding at a reasonable cost, offsetting the widening of spreads.
While the specifics of the guarantee vary between countries and issuers, there are some basic common characteristics, said Marasciulo: eligible instruments; eligible institutions; limits on amounts of issuance guaranteed; fees; and windows of availability.
The French agency Caisse d’Amortissement de la Dette Sociale (Cades) is 100% owned by the French government. The Italian Cassa Depositi e Prestiti (CDEP) is 80% owned by the Italian government. Bank Nederlandse Gemeenten, the Dutch agency, is 50% owned by the Dutch government and 50% by Dutch municipalities and provinces.
None has an explicit guarantee, but the important role each plays in its respective national economy ensures the possibility of the failure of an SSA issuer with even just an implicit guarantee remains “pretty remote”, said Marasciulo.
Pepperell does not think such a failure is likely in developed markets. However, in China it is more likely, he said, though it remains difficult to predict how the market would respond to such an event.
It is enough of an added layer of uncertainty to discourage some investors, accounting for the superior liquidity in sovereign paper. Investors with significant resources dedicated to researching the nuances of agency debt can therefore extract value from it – and this process is not only necessary to properly price agencies, but banks too, which are increasingly viewed with some level of implicit guarantee.
Barbe said: “BNPAM has experience in this area so that has traditionally been a big advantage, though today the official data from Reuters and others is much closer to reality than it was in the past. That makes it easier for smaller investors to price, for example, a smaller Austrian issuer with a guarantee from a region.”
Network Risk Models can help investors better understand the risk of an SSA issuer being allowed to fail, said Pepperell, by helping them define the risk. If they understand the liquidity risk, particularly who the holders of the asset are, it is clearer what the policy response is likely to be, shedding light on the possible consequences of failure.
Until the market is presented with such a scenario, attention will focus on the global economy and politics, with local factors influencing specific credits.
“Whilst European governments have a more favourable monetary policy background, they contain higher political risk this year,” said Pepperell. “Brexit and various independence and nationalist/populist movements may cause volatility in the shorter end of the curve.”
There is also the possibility of another shock tipping the world back into recession, though a slowdown is more likely in the 2017–2020 window than in 2016, said Pepperell. “Natural business and economic cycles will marry up at a time when fiscal and central bank policies near exhaustion and political capital will be lower.”
If this transpires, central banks may cut interest rates further into negative territory, while governments “push through a Keynesian infrastructure spending initiative as the next grand experiment”, added Pepperell.
This would have significant implications for SSA investors, implying increasing supply to finance this state largesse, putting downward pressure on prices. By then, QE fatigue might also make it harder for the ECB to keep supporting prices.
There are too many variables at play for investors to make informed investment decisions on this kind of horizon, so while they might have such thoughts in the backs of their minds, today’s investment decisions are likely to be informed by nearer term considerations.
But the market should be prepared for the worst, warned Pepperell: “Investors need to increasingly focus on return of their capital, rather than return on it.”