Why European investors might consider fixed maturity investing?

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The search for yield presents European investors with a conundrum at the moment.

Interest rates in the eurozone remain stubbornly low and while rates in other parts of the world, including the United States, have started rising from historic lows, hedging costs can make that an expensive option.

European investors pay a significant premium to hedge dollar assets back to euros. That can quickly eat away at any return advantage that US assets might offer compared with European assets.

Little Sign of the Interest-Rate Tide Changing Soon

The latest figures suggest economic growth in the eurozone is slowing. On top of that, the region faces a series of political headwinds. For example, we expect Brexit to impact the wider region more deeply than some are predicting.

Furthermore, European Parliament elections are due to take place in May, bringing the very real prospect of populist parties from the extreme left and right of the political spectrum making gains.

All things considered, we reckon the prospect of eurozone interest rates starting to rise imminently has receded. But, like all investors, we hope and expect interest rates will rise eventually.

Our analysis suggests the European Central Bank (ECB) likely won't start hiking rates until 2021.

Against this background, we're seeing a resurgence of interest in so-called "buy-and-hold," or fixed maturity investment strategies.

Limiting Duration Risk

Although growth has been slowing down in the eurozone, it still appears healthy from our point of view, and we are not worried about the risk of a recession in the region. Domestic demand, as well as consumer and business confidence, appear to still be strong.

While we're sceptical that eurozone interest rates will rise soon, we recognise that central bankers will act eventually, and that the next movement is likely to be a rate hike.

So for many investors, duration risk—in other words exposure to changing interest rates—remains a prominent concern.

A fixed maturity investment can reduce that exposure. An investor holding bonds that mature in line with his or her investment horizon likely will not care what happens to interest rates in the meantime, as long as they are being paid their coupon.

Re-emergence of Credit as an Attractive Consideration

The challenge, therefore, is seeking out an appropriate coupon.

In the current sustained low-interest-rate environment, we think credit is emerging as an attractive asset class for investors seeking income. In recent months, both high-yield and investment-grade credit have sold off significantly.

The asset class rallied somewhat in January but still spreads remain much wider than they were in the middle of last year.

While corporate credit comes with a higher risk of defaults than sovereign debt, we feel investors are now getting better compensated for that risk.

Furthermore, default rates are low at the moment, and we'd anticipate they should likely remain low for several years.

Still, we think it's important to look at credit in a diversified manner and not to overly concentrate on individual corporate names.

And as ever we remain strong proponents of an active investment management approach. That should mean if the fundamentals of assets within the fixed maturity portfolio do deteriorate, action can be taken and potentially new assets with similar maturities swapped in.

David Zahn, Head of European Fixed Income at Franklin Templeton