Investors in Riskier Bonds May Not be Coming Back
Governments on the edges of the euro zone face a serious new challenge: the prospect that investors who have shunned their bonds in recent months may abandon them for good.
While European leaders continue to say that all euro-zone government debts will be paid in full and on time, most big investors don’t believe them. A survey of 582 investment institutions, carried out by Barclays Capital and released last week, showed 82% of them expected either debt restructuring, default or a full-fledged euro-zone crisis.
But the shift out of government bonds of Greece, Portugal, Ireland and even Spain is not just to do with the fear that investors will not be repaid in full and on time. It has also happened because the violent price shifts that have taken place over the last year mean that their bonds have lost many of the characteristics that most big bond buyers are seeking. “I think the biggest structural shift has been in market volatility,” says Arif Husain, director of U.K. and European fixed income at AllianceBernstein, the asset-management firm.
He says investors usually buy bonds for one of four reasons:
Many conservative investors are seeking security for their capital. After assuming for much of the last decade that they were buying safety in places like Greece—to the point where yields on Greek bonds fell almost to the levels of those on German bonds—they now discover it was an illusion.
Justin Knight, European rates strategist at UBS in London, says a host of investors—including U.S. bond funds with retail clients and non-European central banks, particularly in Asia—invested in such “peripheral” markets to secure higher yields, thinking at the same time they had secured low-risk and low-volatility. Now, they’ve been disabused, and have pulled out “not because they think governments on the periphery are going to default but because they shouldn’t have been there in the first place,” he says.
• They are seeking assets that move in the opposite direction to stocks.
This so-called negative correlation protects the value of their portfolio if prices of one asset class declines. Yet since the onset of the Greek crisis, at least until quite recently, prices of peripheral euro-zone debt have moved in tandem with risky assets such as shares, an undesirable positive correlation..
• Liability management.
Investors such as pension funds want to align their assets to their liabilities, so that their investments mature at the same time as future payouts to pensioners. Dutch pension funds, for example, thought they could match their liabilities with assets such as Spanish bonds. Now, the possibility of default has made them think again.
• Income generation.
Here the bonds from the periphery still do the job, now providing a bigger yield pick-up over German bonds than they did before, largely because the risks are perceived to be much higher.
The importance of investors in the fourth category is overwhelmed by those in the first three, and experts say their retreat is not a short-term phenomenon. “Bond markets have long memories,” Mr. Husain says.
Mr. Knight notes another shift among a minority of investors: the changing of benchmarks to exclude all but the euro zone’s core countries. These funds weight their purchases of bonds according to bond indexes, and have been underweight for some time in the peripheral markets. Now they want to formalize that shift, because they don’t see a prospect of those markets providing low credit risk and low volatility.
“We have several accounts that are changing their benchmarks. That’s a big deal. You have to explain to your clients what you are doing and why you are doing it. It’s not something that you do lightly and you don’t do it often so they won’t be changing back any time soon,” he says.
These factors suggest long-term shifts in investor appetites that will radically shrink the universe of buyers for bonds from the euro zone’s periphery for the foreseeable future.
Supply, meanwhile, is coming at full tilt.
Although governments are making stringent efforts to cut budget deficits, they won’t be able to do that quickly enough to scale back soon the flood of issues needed to cover the deficits and repay maturing debt. For a year or two, gross bond issuance will be running at two, three or four times the levels of the pre-crisis years, Mr. Knight says—even as demand has shrunk.
Selling these bonds will be a challenge. As politicians discuss ways to prevent the next crisis at the European Union summit continuing Friday in Brussels, this dynamic in the bond markets suggests they shouldn’t be too confident about having surmounted the current one.
Write to Stephen Fidler at email@example.com
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