Navigating European fixed income - Could the short end of the yield curve hold the answer?

Jonathan Boyd
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Navigating European fixed income - Could the short end of the yield curve hold the answer?

The economic situation in Europe has been challenging over the past few years. Political events in Europe coupled with increasing uncertainty around rising rates and historically low to negative yields, have left many investors scratching their heads about where to put their cash.

Why hold European short dated bonds?

Over the last few years, the European Central Bank’s (ECB) accommodative monetary policy combined with a market pessimistic on growth has seen a prolonged bull market in bonds, pushing yields to historically low levels. As at the end of January 2017, 63% of bonds in the BoA ML 1-5 year European Broad Market Index had negative yields, and two-year German bonds have traded at historically low levels (Chart 1). This means in some cases investors are literally paying to invest their money.

However, for investors faced with negative returns on traditional safe haven investments, now might be the opportune time to modestly extend duration. In recent weeks corporate bond spreads in Europe have widened, which some attribute to political volatility in the region. Despite the volatility we are seeing however, we think that the corporate fundamentals remain strong in Europe, meaning the increased volatility is actually providing good buying opportunities for active managers who know where to look. Thus, we think investors could benefit from the addition of European short dated bonds in their overall portfolios, without adding significant additional risk.

In addition, the uncertain interest rate environment continues to be a pain point for investors. Some market participants have been quick to suggest that the modest growth we have seen in Europe could give way to a rate rise in the near future. Our view however, is that growth in Europe will remain slow and steady. Inflation will be moderate but remain far off the ECB’s target of 2.0%. Thus, we believe that the ECB will remain accommodative.

We do think that political volatility in Europe is something to take notice of however. This year will see three key general elections take place across Europe, in France, Germany and the Netherlands with on-going uncertainty in Italy, and the Brexit negotiations in the UK.

What this does mean is increased uncertainty in some European bond markets with spreads in government bonds such as France and Italy continuing to widen. This has been very pronounced in France in particular as the market begins to price in the possibility of far-right presidential candidate Marine Le Pen winning the presidency. Spreads between French and German bonds have been rising dramatically since the end of 2016 (Chart 2).

Shorter dated bonds however, typically have lower volatility in comparison to longer dated bonds. By keeping the maturity of the bonds short, investors are minimising key risks such as interest rate and credit risks which may be suitable given current uncertainty and political environment.

So, where should you look within the European short dated Bond Market?

We take an active, multi-sector, diversified approach in our Franklin Euro Short Duration Bond Fund which turned three years old recently. We look at opportunities in many different EUR denominated sub-sectors, from investment grade, to high yield, to short dated and fixed floating-rate debt securities. Our strategy can also invest up to 10% in non-euro currencies.

We favour investment grade corporate bonds, a position we have been building since 2015. With negative yields across European governments in the front end of the yield curve, we remain overweight to a diversified basket of investment grade corporate issuers, both European and global in nature. We believe that corporate balance sheets remain strong and we view the spread pick up as adequate to compensate for the reduced liquidity.

We also see value in Italian government bonds. We saw spreads widening around November 2016, as concerns around the referendum results grew. While many in the market remained risk averse, we used the weakness to add to Italian sovereigns, as we felt that the market overreacted.

From a wider European perspective, we see political risks on the horizon in many countries, but we do not yet see these risks reflected in spreads. The Italian three year at the present 100bps spread offers compensation for political risks, whereas three year Spain at 60bps and three year France at 50bps do not.

We also like UK government bonds. Although inflation has risen in the UK, the uncertainties surrounding the Brexit negotiations mean the Bank of England is likely to remain accommodative. As such we invest in UK gilts on a currency hedged basis to maintain a sufficient liquidity buffer and a position that will benefit from a flight to quality should the economic situation in Europe or the UK deteriorate – essentially a hedge for Brexit being more aggressive than markets are pricing in.

Another key pick for us is inflation-linked bonds. While we view inflation as likely to remain fairly low for the near future, we think short-dated breakevens have provided a cheap source of inflation protection.

We think there is significant opportunity at both the short and long ends of the curve, but given current market dynamics, European short dated bonds can provide a good alternative to holding cash, and provide a buffer against the significant on-going volatility in the European region that we expect this year.

 

David Zahn is head of European Fixed Income, Franklin Templeton Fixed Income Group