Monday 21 August 2017

Plenty of opportunities in eurozone's dance of death -- if you're feeling brave

Laura Noonan

Laura Noonan

THERE are very good reasons to be scared of Europe's sovereign bond markets these days, not least the complete chaos that repeatedly threatens to create the ultimate Greek tragedy.

But for the battle-hardened few who still have the stomach for eurozone government bonds, the next couple of weeks will offer a very particular buying opportunity.

On March 1, Europe's banks are expected to get about €500bn from the European Central Bank for an unprecedented term of up to three years at a starting interest rate of 1pc.

It's unprecedented in "normal" ECB terms but it has happened once before when Europe's banks drew down the first three-year money they were ever offered in late December.

That three-year operation had swift and profound repercussions for the government debt markets of the countries whose banks were the biggest takers.

A lot of banks simply took the 1pc money from the ECB and pumped it into their sovereign bonds which were yielding rates of more than 7pc in Ireland, or more than 6pc in Italy.

Take the Irish example. On December 22, when the three-year money was paid out to our banks, the yield on a government bond with two years left to run was 7.6pc.

By January 9 that same yield had fallen to 6.9pc, 10 days later it was down as far as 5.5pc and by February 3 the yield had fallen below the 4.4pc threshold.

In the space of just six weeks, the yield on that 2014 bond fell more than 70pc -- good news for the Government, since it makes Ireland's debt costs look more sustainable.

But it was also very good news for an investor who bought the bond on December 22 for a price of 93.368 and managed to sell it on February 3 for 99.305. That's a 6pc return over six weeks, which annualises to a very healthy 65pc or so. Nice work if you can get it.

The ECB money had a similar impact in Italy, where a bond repayable in January 2015 stood at 6.22pc when the three-year money was released on December 22 and fell all the way to 4.17pc by February 3.

And in Spain, another one of the troubled "peripheries", a bond with a January 2015 maturity was commanding a yield of 3.86pc on December 22 and a yield of just 2.72pc by February 3.

The effect wasn't confined to bonds with 2014 and 2015 maturities, even though those were the bonds that most closely matched what the banks were looking for.

In Ireland, the yield on a 2020 bond was at 8.27pc on December 22, and had come back to 6.89pc by February 3 as the bond's price rose from 80.05 to 87.908.

In Italy, the yield on a 2021 bond fell from 7.47pc to 6.5pc over the six weeks, while in Spain the yield on an April 2012 bond fell from 5.32pc to 4.73pc.

The banks themselves probably weren't buying up the longer maturity bonds, but the fall in the yields of shorter maturity bonds led to greater confidence in the countries generally, and encouraged non-bank buyers to 10-years and the like.

That doesn't mean that the upcoming influx of more ECB money into the banks is a good reason to buy European sovereign bonds indiscriminately.

The December-February effect has been largely confined to banks in the so-called peripheries, possibly because those countries' banks needed more ECB money and possibly because those countries' debts were higher yielding and therefore more attractive.

Whatever the cause, yields in 'safer' eurozone countries have moved far less -- France's three-year yield came down less than half a percentage point, while Germany's three-year yield fall was even more marginal. Investors looking for big gains from the next ECB offering probably won't be looking to those two countries.

Then there was Portugal, the major exception to the peripheries rule, where three-year yields went soaring from December 22's 15.7pc to a high of 22.4pc on January 30 amid fears the country was about to become the next Greece.

Greece, needless to say, has been completely outside the action and is likely to remain so, with its yields in recent weeks entirely dependent on the ebb and flow of agonisingly slow talks over debt write-downs and structural reforms.

Investing in both Greece and Portugal's bonds comes with a multitude of health warnings, and it's a fair bet that the influx of ECB money will have far less of an impact on their bond yields that their wider economic problems. In other words, those looking for the ECB effect are best off to look elsewhere.

The other important thing to bear in mind about that "elsewhere" is that yields in the "peripheries" that saw the greatest December-February effect are starting from a lower base this time round.

No matter how much cash the Irish banks take in, and no matter how single-minded they are in their spending on that money, it's highly unlikely that yields on that 2014 bond have another 3pc to go (particularly since that would put them in German territory).

That doesn't mean there won't be any benefits for the periphey countries' debt when the next ECB cash comes through, but gains are likely to be more muted this time round.

In that context, countries like Austria might be more worthy of examination -- the yield on their 2014 bond has gone nowhere since December 22 and stood at 4.9pc on February 3 (that's right, a higher yield than Ireland's).

Just because banks have traditionally ploughed their money into bonds from their own sovereigns doesn't mean they'll keep doing that, particularly if their own sovereigns now have unattractively low yields.

Plenty for investors to ponder over the next few weeks then, but only if they're hardy enough to take on the eurozone dance of death in the first place.

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