Diving into the riskiest parts of Europe’s government bond market proved to be a clear winner last year.
Some of the world’s biggest money managers say 2016 will be no different.
BlackRock, Pacific Investment Management Co and Prudential Financial all say debt from Europe’s peripheral nations - those less-creditworthy borrowers such as Portugal, Italy and Greece - are primed to excel once again as the European Central Bank extends its unprecedented bond buying. With the Federal Reserve finally raising US interest rates, they’re taking a dimmer view of Treasuries as forecasts suggest the securities are headed for losses.
While Europe was roiled by concern a Greek default would splinter the currency union, international investors are nevertheless wading deeper into the riskiest euro nations - a vote of confidence that suggests its members can avoid a repeat of crises over the years that almost tore the region apart.
Tepid growth and the risk of deflation also mean ECB President Mario Draghi may need to step up stimulus in 2016 - which JPMorgan Chase & Co says will help Europe outperform the US as monetary policies diverge.
“A lot of these credits that were feared to be disasters like the peripherals from Spain all the way down to Greece, had events for years and there’s going to be political and economic challenges going forward but those have been the best performers,” said Robert Tipp, the chief investment strategist at the fixed-income unit of Prudential, which oversees $947bn globally.
Tipp said the firm’s global funds are maintaining their “overweight” stance on bonds of peripheral countries in 2016, which means they hold a greater proportion of the securities than their allocation in benchmark indexes.
Greek bonds returned 22% as the Mediterranean country recovered from a debt showdown with creditors led by Germany and implemented measures to curb government spending. Debt issued by Italy and Portugal also returned more than 3%. Higher-rated countries, such as Germany and the US, have lagged behind.
Although the greenback’s appreciation this year would have eroded those returns for dollar-based money managers, Tipp says most big global investors hedge away that risk when they invest outside their home country. In fact, quirks in forwards market pricing have meant dollar-based investors have added to their returns when hedging, Tipp said.
Going into 2016, Portugal is a favorite for Scott Thiel, BlackRock’s deputy chief investment officer for fundamental fixed income.
A big reason is the potential return on Portugal’s debt. At 3.7%, the country’s 30-year bonds yield almost 2.4 percentage points more than comparable German bunds, the region’s benchmark.
Gains are likely to increase as the nation’s economy improves and the ECB’s debt purchases - which currently stand at €60bn ($65bn) a month - drive prices up and reduce the yield gap between the two markets.
Even after Portugal’s ruling coalition lost power to the minority Socialist government last month, the nation’s borrowing costs have fallen faster than those of Germany.
It’s an “obvious investment,” said Thiel, whose New York- based firm oversees $4.5tn as the world’s largest money manager.
BlackRock is the biggest owner of Portugal’s bonds due in February 2045, holding more than 10% of the securities, data compiled by Bloomberg show. They have returned in excess of 10% since they were issued at the start of the year.
Investors were reminded of some of the risks of holding lower-rated debt. Spanish bonds fell after an inconclusive election on Sunday put the nation in uncharted political territory that could require long negotiations before a government is formed. While Spain’s 10-year yields climbed the most in a week, the reaction was muted across the rest of the euro area.
Pimco, which oversees $1.47tn globally, is also bullish on peripheral bonds such as those issued by Greece. Despite the relative lack of liquidity for the securities, the firm is the largest holder when it comes to investment advisers, regulatory filings compiled by Bloomberg show.
Among the firm’s biggest investments in Greek debt are notes due in April 2019, held by the $52bn Pimco Income Fund, the data show.
Since slumping below 40 cents in July, when Greece was at the brink of financial ruin, the notes have soared and now trade at about 92 cents. And while average borrowing costs are hardly low by standards of developed nations, those for Greece have tumbled from a peak of 22% this year to 8% today, data compiled by Bloomberg show.
“They’ve gotten the Greece drama behind them, Draghi is running the appropriate and effective policy and so there are opportunities in the European periphery bonds,” said Richard Clarida, the global strategic adviser at Pimco.
That contrasts with the firm’s “underweight” on Treasuries. Particularly for shorter-dated debt, the bearishness reflects the prevailing view that Draghi will have to step up the ECB’s stimulus to combat weakening growth and inflation, at a time a stronger US economy pushes Fed Chair Janet Yellen to tighten policy, said Gianluca Salford, JPMorgan’s European rates strategist.
“The message is very, very clear,” he said. According to the median forecast in a Bloomberg survey, yields on 10-year Treasuries will rise to 2.75% by the end of 2016 from about 2.22% now. If that happens, investors will lose about 1.9%.
Since the late 1970s, US government bonds have posted annual losses just four times - in 1994, 1999, 2009 and 2013, data compiled by Bank of America Corp show.