Don’t count on a future bailout for Euro bonds

INVESTORS are increasingly looking for new ways to find decent income as most western bond yields sink ever lower. Many are flooding into emerging market (EM) debt, with iShares having seen its EM bond fund swell to over $1bn.

Others are looking closer to home – and they don’t have to look far. Markets are jumpy, as shown by the 10-point spike in 10-year Irish yields in response to Fitch’s downgrade yesterday. Deutsche Bank this week added two funds to its db x-trackers range, with one tracking the iBoxx Eurozone high yield index and the other tracking overall Eurozone sovereign debt. Head of db x-trackers’ Manooj Mistry says that investors are attracted to exchange-traded funds to buy bonds because it means they don’t have to rebalance their portfolios every time the situation changes – the index does it for them. The new funds are listed in Germany, but UK investors can tap into the high yields of the European sovereign bond market through iShares’ numerous Eurozone bond products.

Demand at recent bond sales in the Eurozone periphery has beaten expectations: Ireland, Spain and Greece all held succesful auctions last month. But with European Central Bank (ECB) bond purchases having risen slightly, many suspect the Bank of stepping in to prop up demand and prevent yields from rising further. Irish 10-year yields are now at 6.4 per cent and Portugal is not doing much better at 6 per cent. Investors can take advantage of these yields in the short-term – since the ECB’s actions tend to be retroactive rather than preventative – but should recognise that the ECB is unlikely to allow yields to rise too high before it starts buying more.

These yields compare very favourably to core Eurozone yields – Germany offers just 2.2 per cent. The question for investors is whether the risk premium of 3-4 per cent accurately reflects the chance of a default. Analysts at BNP Paribas point to Ireland and Spain’s decline in PMI as diverging from the overall trajectory of the Eurozone in September, which offered more good surprises than bad. BNP forecasts double dips for both countries, and IMF growth projections are not much better.

But Evolution Securities’ Gary Jenkins thinks the market might be overly optimistic in pricing in a bailout of the most indebted Eurozone countries: “Clearly there isn’t a default scenario being priced in because otherwise the yields would be a lot higher,” he says. While relying on a bailout might make sense in the short-term, Jenkins is not sure it is wise to bank on it beyond the next couple of years. “At the moment Europe daren’t do anything other than bail them out because the system is so fragile that if one country fails the knock-on impact could lead to a complete meltdown. But fast forward four years: if the economic outlook is rosier, the ECB might allow one of them to go.”

This means that even while choosing European high-yield bonds over their EM counterparts, investors would be wise to keep a narrow time horizon. The ongoing Eurozone crisis has shown that buyers would be foolish to assume that Europe’s governments are insulated from default. In the long-run, a steadily growing emerging market government with a decent yield could be a safer bet.