Diving into the riskiest parts of Europe's government bond market proved to be a clear winner this year.
Some of the world's biggest money managers say 2016 will be no different.
BlackRock Inc., Pacific Investment Management Co. and
Prudential Financial Inc. all say debt from Europe's peripheral nations — those less-creditworthy borrowers such as Portugal, Italy and Greece — are primed to excel once again as the European Central Bank extends its unprecedented bond buying. They're taking a dimmer view of Treasuries with the
Federal Reserve finally raising U.S. interest rates and forecasts suggesting the securities are headed for losses.
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While Europe was roiled by concerns that a Greek default would splinter the currency union, international investors are nevertheless wading deeper into the riskiest euro nations — a vote of confidence that suggests its members can avoid a repeat of crises over the years that almost tore the region apart. Tepid growth and the risk of deflation also mean ECB President Mario Draghi may need to step up stimulus in 2016 — which JPMorgan Chase & Co. says will help Europe outperform the U.S. as monetary policies diverge.
“A lot of these credits that were feared to be disasters, like the peripherals from Spain all the way down to Greece, had events for years and there's going to be political and economic challenges going forward, but those have been the best performers,” said Robert Tipp, the chief investment strategist at the fixed-income unit of Prudential, which oversees $947 billion globally.
Mr. Tipp said the firm's global funds are maintaining their “overweight” stance on bonds of peripheral countries in 2016, which means they hold a greater proportion of the securities than their allocation in benchmark indexes.
CHARGING AHEAD
Those nations have led the charge this year. Greek bonds returned 22% as the Mediterranean country recovered from a debt showdown with creditors led by Germany and implemented measures to curb government spending. Debt issued by Italy and Portugal also returned more than 3%. Higher-rated countries, such as Germany and the U.S., have lagged behind.
Although greenback appreciation this year would have eroded those returns for dollar-based money managers, Mr. Tipp says most big global investors hedge away that risk when they invest outside their home country. In fact, quirks in forwards market pricing have meant dollar-based investors have added to their returns when hedging, he said.
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Going into 2016, Portugal is a favorite for Scott Thiel, BlackRock's deputy chief investment officer for fundamental fixed income.
A big reason is the potential return on Portugal's debt. At 3.7%, the country's 30-year bonds yield almost 2.4 percentage points more than comparable German bonds, the region's benchmark.
Gains are likely to increase as the nation's economy improves and the ECB's debt purchases — which currently stand at 60 billion euros ($65 billion) a month — drive prices up and reduce the yield gap between the two markets.
Even after Portugal's ruling coalition lost power to the minority Socialist government last month, the nation's borrowing costs have fallen faster than those of Germany.
'OBVIOUS INVESTMENT'
It's an “obvious investment,” said Mr. Thiel, whose New York-based firm oversees $4.5 trillion as the world's largest money manager.
BlackRock is the biggest owner of Portugal's bonds due in February 2045, holding more than 10% of the securities, data compiled by Bloomberg show. They have returned in excess of 10% since they were issued at the start of the year.
Investors were reminded of some of the risks of holding lower-rated debt. Spanish bonds fell after an inconclusive election on Sunday put the nation in uncharted political territory that could require long negotiations before a government is formed. While Spain's 10-year yields climbed the most in a week, the reaction was muted across the rest of the euro area.
Pimco, which oversees $1.47 trillion globally, is also bullish on peripheral bonds such as those issued by Greece. Despite the relative lack of liquidity for the securities, the firm is the largest holder when it comes to investment advisers, regulatory filings compiled by Bloomberg show.
GREEK DRAMA
Among the firm's biggest investments in Greek debt are notes due in April 2019, held by the $52 billion Pimco Income Fund, the data show.
Since slumping below 40 cents in July, when Greece was at the brink of financial ruin, the notes have soared and now trade at about 92 cents. And while average borrowing costs are hardly low by standards of developed nations, those for Greece have tumbled from a peak of 22% this year to 8% today, data compiled by Bloomberg show.
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“They've gotten the Greece drama behind them, Draghi is running the appropriate and effective policy and so there are opportunities in the European periphery bonds,” said Richard Clarida, the global strategic adviser at Pimco.
That contrasts with the firm's “underweight” on Treasuries. Particularly for shorter-dated debt, the bearishness reflects the prevailing view that Draghi will have to step up the ECB's stimulus to combat weakening growth and inflation, at a time when a stronger U.S. economy pushes Fed Chair Janet Yellen to tighten policy, said Gianluca Salford, JPMorgan's European rates strategist.
“The message is very, very clear,” he said.
According to the median forecast in a Bloomberg survey, yields on 10-year Treasuries will rise to 2.75% by the end of 2016 from about 2.22% now. If that happens, investors will lose about 1.9%.
Since the late 1970s, U.S. government bonds have posted annual losses just four times — in 1994, 1999, 2009 and 2013 — data compiled by
Bank of America Corp. show.
NEW NORMAL
Still, Treasuries have been a far better investment than most euro-denominated bonds for investors who chose not to hedge their currency risk.
For Japanese yen-based bond buyers, Treasuries have returned 2.6% this year, while losing 7.2% on euro-sovereign debt, data compiled by Bloomberg show. Japanese investors have been buying U.S. bonds and paring euro-area debt, with the biggest sales coming at the expense of German bonds.
Even Mr. Clarida at Pimco says regardless of where you invest, returns will be meager.
“We are in a low-return world, there's no doubt about it,” he said.
That's prompted BlueBay Asset Management's Mark Dowding to look further afield. He's a fan of Cyprus, which has improved since the emergency rescue package in 2013. Moody's Investors Service raised its rating for the country's debt last month, citing a faster-than-expected economic recovery and Cyprus's ability to meet its fiscal targets.
Since they were sold in October, Cyprus's euro-denominated 10-year bonds have rallied, pushing down yields from 4.25% to 3.88%.
“In Europe, we continue to believe that in the periphery, spreads can continue to grind tighter,” said Mr. Dowding, who helps oversee $60 billion at BlueBay.
BlackRock's Mr. Thiel says the biggest opportunities lie beyond the highly-rated debt markets of the U.S., Germany and the U.K., which provide little in return beyond the low yields that they carry.
“If I look forward into 2016, I don't see a reason to own gilts, I don't see a reason to own Treasuries, and I don't see a real reason to own bunds,” he said. “In Europe, peripheral markets are still very attractive.”
