Unrelenting demand for fixed income has pushed yields, in Europe at least, to a point where investors no longer distinguish one country’s bonds from another’s – potentially storing up trouble for when focus returns to the economic drivers behind borrowing costs.
Individual countries’ credit ratings, political risks and fiscal and economic performance have been pushed aside as a global hunt for yield has gathered pace since Britain voted in favour of leaving the European Union in a June referendum.
The result darkened Europe’s growth outlook and triggered a fresh wave of monetary easing from central banks.
Highlighting the impact on yields, lower-rated Spanish 10-year government bonds have joined their higher-rated peers in France, Belgium and Finland with a yield at record lows below one per cent .
That pushed the yield gap over top-rated German bonds to just over 100 bps – levels that in the past have not been sustained for long periods. In Italy, which has a lower credit rating than Germany and France, 10-year yields are just above one per cent and at levels some fund managers believe do not reflect banking sector problems or political uncertainty linked to a looming referendum.
“There’s barely any discrimination among sovereigns anymore,” said Frederik Ducrozet, senior economist for Europe at Pictet Wealth Management. “It’s a potential recipe for disaster if and when those bonds are repriced.
Since Britain voted in June to quit the European Union, yields across Europe have fallen sharply to close proximity to each other
The European Central Bank’s €1.74 trillion asset-purchase scheme provides a powerful buffer to regional bonds and made them less sensitive to country-specific dynamics.
But investors are not completely shielded from a change in market sentiment or a trigger for a broad sell-off that could see the bloc’s weakest members bear the brunt of selling.
Analysts point to last year’s unexpected bond rout, triggered by a pick-up in inflation as an example. While German Bund yields rose about 100 bps between April and June last year, Spanish and Italian yields climbed over 120 bps each.
A sell-off in Portuguese bonds last Tuesday after ratings agency DBRS said pressures were building on Portugal’s country’s creditworthiness was also a reminder of just how quickly yields can rise when focus returns to domestic issues.
Potential triggers for a reassessment of the bond market could come from economic data or outside Europe if talk of another US interest rate hike gains ground, analysts said.
“In a scenario of a large generalised pull-back in government bonds yields, the bonds with the most perceived risk are likely to be the most vulnerable. This is what we saw in March-June last year,” said Antoine Bouvet, rates strategist at Mizuho International.
“In the case of the periphery, there are currently enough risks to those countries to expect that spreads will widen in a generalised sell-off.”
A Federal Reserve official said on Tuesday there could be as many two rate hikes before the new year, and another said a move could come as soon as next month.
Since Britain voted in June to quit the European Union, yields across Europe have fallen sharply to close proximity to each other.
With more than $13 trillion of government and corporate debt yields globally in negative territory, investors have been pushed into seeking higher returns in longer-dated debt, lower-rated peripheral bonds and emerging market debt.
That help explains why yields on Spanish and Italian bonds are lower than those on benchmark US 10-year Treasuries, which stand at 1.58 per cent .
For Oksana Aronov of JPM Income Opportunity Fund, the backdrop of negative yields is one reason why bonds have become less sensitive to “fundamentals” – the economic and political dynamics that usually effect the pricing of a bond.
“Bonds have long served as the anchor in a conservative portfolio, a “safe-haven” asset with an income component designed to produce a consistent return stream,” she said in a note.
Given the rise in negative-yielding debt, “bonds increasingly cease to trade based on fundamentals, such as yield, and trade instead on what someone else might be willing to pay for them in the future,” Aronov added.
With little difference in yield between European issuers, it is even more important to do a “fundamental analysis” because taking on extra risk is not compensated for with a higher yield, said David Zahn, head of European fixed income at Franklin Templeton Fixed Income Group.
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