ECB pledge boosts bets on debt of eurozone periphery

091712 draghi
Liking: Managers welcomed Mario Draghi's pledge to purchase bonds of some European nations.

Some bond managers are making hay on the recent turnaround of sovereign debt issued by peripheral eurozone countries as European leaders have made sweeping commitments to solve a debt crisis now in its third year.

Managers' strategic purchases of these bonds are in stark contrast to earlier in the crisis, when managers would only dip in and out of these struggling countries' debt tactically.

BlueBay Asset Management LLP, Franklin Templeton (BEN) Investments (BEN), J.P. Morgan Asset Management (JPM), Loomis Sayles & Co. LP, Pacific Investment Management Co. LLC and Prudential Fixed Income all have been buying one or more of the eurozone peripheral countries of Ireland, Italy, Portugal and Spain. Most managers are still avoiding Greek bonds because of default risk or being too lowly rated for inclusion in their strategies.

The buying gathered momentum ahead of the Sept. 6 speech by European Central Bank President Mario Draghi, in which he committed to buying short-term debt of European countries to suppress yields.

“The ECB delivered everything the market was expecting, and the details were significant,” especially that buying was effectively unlimited and that the bank would take an equal legal position to other creditors, said Nick Gartside, international chief investment officer for fixed income at J.P. Morgan Asset Management in London. “It's not without implementation risk, but at least now we know the rules. That's a very big difference from even just a few weeks ago.”

Mr. Gartside had moved to neutral from an underweight position earlier in the year, and near the time of Mr. Draghi's speech he moved to overweight Spain and Italy. He also increased positions in Irish debt about a month ago. “We felt there's a risk that Ireland is upgraded (and that) valuations were attractive compared to other eurozone bonds,” he said. His $3 billion strategic bond fund returned 4.9% gross of fees in the eight months through Aug. 31 vs. 0.37% for the London interbank offered rate; the three-year annualized return was 8.05% vs. 0.55% for the benchmark.

“In a world where yields are really low, a lot of those countries represent very attractive opportunities,” said Robert Tipp, managing director and chief investment strategist of Newark N.J.-based Prudential Fixed Income, which runs $348 billion. In the $272 million Prudential Global Total Return Fund, Mr. Tipp has moved to overweight on government bonds from Spain, Portugal, Italy and Ireland. The fund has returned 8.81% so far in 2012 and an annualized 9.63% in the three years to Aug. 31.

More than ever, managers are convinced European policymakers will drive — or will be driven to — tighter fiscal and political integration of the 17-member union. That's giving managers the confidence to venture into these riskier government securities, but they recognize the road to unity will be bumpy and uncertain, so they're staying tactical, too.

Push toward integration

“That's certainly the direction of travel at the moment. But I think that journey is a slow, slow journey,” and valuations are being determined by short-term dynamics, Mr. Gartside said.

Mark Dowding, partner and co-head of investment grade at BlueBay Asset Management, London, said: “It's really only been since the start of this year that we've had a more constructive stance” on Spanish and Italian bonds, which he'd previously only held in relative value trades.

Mr. Dowding is relatively optimistic about the future of the eurozone and has taken directional bets on Spanish and Italian bonds. But he invests in sovereign bonds in Europe, even for corporate bond strategies, because of their greater liquidity — that's necessary when trading opportunistically, which he'll continue to do in the periphery. “There will be cycles of volatility, and that's what provides us investment opportunities,” he said.

BlueBay has started taking profits on some of these bonds, following a method in which it buys during times of stress and sells following relief rallies. The method delivered 11.1% in the first half — in euro terms and gross of fees — in the firm's long-only European investment-grade euro government bond fund, topping the Barclays Capital Euro Aggregate Treasury index by 543 basis points. Annualized performance since its Dec. 22 inception is 10.15% vs. 5.58% for the benchmark.

Kathleen Gaffney, vice president and portfolio manager at Loomis, Sayles & Co. LP, Boston, has experienced firsthand the riskiness of peripheral debt. “We've been watching this space for quite some time” and ventured into Irish, Greek and Portuguese debt starting in 2010. She lost money on Greek and Portuguese positions, but Ireland was a winner. So when Italian and Spanish yields recently pierced 7%, she bought. “That, in our minds, represented good value,” she said.

She's also bought corporate bonds in the periphery, which are a “bargain” compared to U.S. high yield, she said. Ms. Gaffney's go-anywhere strategy, in which she runs $21.4 billion, returned 11.08% net of fees as of Aug. 31 and an annualized 12.27% over three years.

Political fate

Periphery naysayers cite the fact that Europe's fate — and that of some of its sovereign bonds — lies in the hands of not markets or macroeconomics but politics.

“The solution to this problem is political. By definition that makes the outcome difficult to gauge,” said Russell Silberton, head of developed rates and currency at Investec Asset Management, London. “We don't think the risks are worth the rewards.”

Mr. Silberton said the valuations of some peripheral bonds were “absolutely” tempting. “The problem is, the level of the risk premium in those markets is highly uncertain. At best, it's a guess,” he said.

Michael Cirami, vice president and portfolio manager at Eaton Vance (EV) Management (EV), Boston, said the ECB's commitment to buy bonds doesn't address the solvency or competitive issues of peripheral countries: “It's just the latest example of kicking the can down the road.”

Instead of peripheral bonds, Mr. Cirami likes bonds of the “CE4,” or central Europe four, “Europe's other periphery” of Poland, Czech Republic, Slovakia and Hungary.

Mr. Silberton said that as some government bonds have taken on credit-like characteristics, he's looked to bonds from countries outside the eurozone, like Sweden and Norway, to boost returns while keeping risk low.

But BlueBay's Mr. Dowding doesn't buy the argument that it's safer to invest in only AAA rated government bonds, or in funds that do. “Those funds have actually seen negative returns and greater volatility than those (strategies) that have performed better,” he said. “Instead of a risk-free return, what you end up with is a return-free risk.”

Reporters Thao Hua of Pensions & Investments and Jeff Benjamin of P&I's sister publication InvestmentNews contributed to this story.

This article originally appeared in the September 17, 2012 print issue as, "ECB pledge boosts bets on debt of eurozone periphery".