Credit market fundamentals go out the window when sentiment and political forces drive global markets. This has been especially true, in recent years, in the approach of institutional non-resident investors in their exposure to peripheral sovereigns – Portugal, Ireland, Italy, Greece and Spain (Piigs). Just as a 10% yield for Spanish 10-year debt, or 8% for Italy in 2012, was probably wrong at the height of the crisis, so too were the paper-thin spreads between Spanish and Italian debt and Bunds seen pre-crisis, as investors wrongly priced in economic convergence.
In recent years, politics has driven the eurozone sovereign debt market, catching analysts off-guard, says Frank Jensen, chief investment officer at Origo, a global macro hedge fund.
“We have definitely seen investors under-analyzing eurozone issues and underestimating the political commitment that exists to the single currency,” agrees Cosimo Marasciulo, head of government bonds and FX at Pioneer Investments.
In theory, mispriced Piigs credits should be attracting fund managers like bees to a honey-pot, but so far hedge fund managers have been the most conspicuous participants, thanks to their stomach for currency convertibility risk.
Their pension-fund colleagues have been tentatively returning to Spanish sovereign debt in recent months, but are still gravitating largely to Bunds, where they are not being compensated for the risk they are taking, says Jensen, given Berlin’s rising intra-eurozone fiscal and banking liabilities.
“People have preconceived ideas about this situation, that south Europeans are over-indebted and too unproductive, and that relieves them of the responsibility of doing their homework,” says Jensen.
Investors remain mindful of default risk, which would leave them in the unenviable position of being forced sellers, and for taking this risk there needs to be a considerable payoff, especially with other asset classes competing for investors’ attention.
A 4.5% yield on Italian 10-year debt is modest compared with the potential returns on offer in the equities market, for example.
Yet the investment case is not purely economic, but political. If you believe Germany will do whatever it takes to hold Europe together, including ultimately transfers of capital to the south, there is a compelling investment case for buying Piigs, says Jensen.
To some extent, pension funds are restricted in their freedom. While it is possible to take a view on sub-investment grade credits, the fact they are not in the index limits the scope for large institutional investors to get involved, says Ben Bennett, credit strategist at Legal & General Investment Management.
Sub-investment grade sovereigns can never comprise the core of a big institutional investor portfolio. If there is a perception that risk appetite is on the cusp of changing substantially, any holdings are typically held as tactical and short-term positions, not on a buy-and-hold basis, adds Bennett.
There is also a substantial reputational risk to investing in such notorious credits when performance is measured against the index, of which these credits are excluded given credit-rating thresholds. “The outlook for peripheral sovereigns still looks pretty ropey, unless you believe in a forthcoming growth miracle,” says Bennett.
However, despite the Italian election shocker, markets still have faith in the ECB’s crisis circuit-breaker – monetary support in return for Berlin-backed fiscal consolidation – and as a result “the reputational risk of investing in peripherals is not as significant as it was last year”, says Marasciulo at Pioneer Investments.
“We can see foreign investors coming back into peripheral credits,” he adds. “Clearly, the Italian election is keeping some people away still, but with so much liquidity in the system what options do you have? Core bonds are offering negative real rates, whereas peripherals offer real pockets of value, and some of them are deep, liquid markets.”
The trend has some way left to run. Currently, peripheral sovereigns do not offer sufficiently attractive returns to make them appealing, says Bennett. Italian 10-year bonds, for example, blew out to more than 350 basis points over Bunds after the Italian election, but this is still scant compensation for the increased risk.
At around 400bp you see a step up in volatility that forces policymakers to intervene, and at that level things get interesting, says Bennett. However, it is at around 500bp over Bunds that market pricing has really detached from reality, making it an attractive proposition.
Yet it is more likely spreads will move the other way, says Marasciulo. “We believe Spanish and Italian 10-year spread over Bunds should be coming down to the level prevailing in the first half of 2011: around 200bps,” he says.
Pension funds therefore remain largely on the sideline. “They were happy to own [Piigs] before the European crisis at nearly zero spreads over Germany, but unloaded in the credit downgrade tsunami,” says Jensen. “They will follow their hedgie colleagues once European political realities become unambiguously clear and when credit upgrades commence.”