Big bond traders double down on bets on Europe

Not even the calamity of disease, debt and Italy's fiscal woes are enough to stop the world's biggest money managers from a trade that's at the heart of Europe.

Investors at Pacific Investment Management Co., Axa Investment Managers and AllianceBernstein are counting on bond prices climbing in Europe's weakest countries, even with yields already hovering near all-time lows. In Italy, Europe's first epicenter of the crisis, bonds have rallied to pre-lockdown levels and the 10-year rate is now a paltry 1%.

But that may be enough. For investors that are having to scrape the barrel for returns, there are good reasons to buy European assets. Political leaders have backed an enormous amount of stimulus for the region and against a landscape of about $16 trillion of bonds with negative yields, some interest is better than none at all.

"You have the confidence of a monetary anchor that shields sovereign balance sheets," said Nicola Mai, who leads PIMCO's sovereign credit research in Europe. The asset manager, which oversees $1.8 trillion, has a "modest" overweight position in Italian and Spanish debt.

"The belly of the curve is the part where we see some value," he added, referring to bonds that typically have maturities of 5 to 10 years.

Italian bonds strengthened Tuesday across maturities, with 10-year yields slipping toward a five-month low reached last week. The yield premium on the nation's 10-year debt over German counterparts, a measure of risk in the region, is down 2 basis points this week, after falling in each of the last three months.

Buying debt from Europe's periphery comes with risk. The anti-establishment Five Star Movement is the biggest partner in Prime Minister Giuseppe Conte's coalition and it's possible that a populist party with extreme views could eventually gain more power, Mr. Mai said.

There's precedent for that, too. In 2018, a tie-up between Five Star and Matteo Salvini's League party caused spreads to balloon and the 10-year yield reached as high as 3.6%.

The other issue is Italy's extreme debt burden. The nation's debt to gross domestic product ratio was already expected to exceed 150% when the government approved another round of spending worth €25 billion ($29 billion).

"What separates Italy from its neighbors is the country's weak long-term outlook — economic fragility can be especially disastrous for a deeply indebted nation," Bloomberg Intelligence economist David Powell wrote in a recent report.

Supporting the bull case is a €750 billion economic rescue package, which investors have interpreted as a guarantee by Europe's strongest countries to use their full arsenal to save the bloc's weakest nations. The spread between Italian and German yields, a measure of risk in Europe, has plummeted more than 150 basis points since a recent peak in March.

"Investors are hopeful that in 'x' number of years, the (European Union) will be looking like a true fiscal, monetary and political union," said Alessandro Tentori, chief investment officer at Axa Investment Managers. "That is very positive for risky assets."

He said Axa boosted exposure to Italian debt in June, and estimates the 10-year yield could fall to 0.75%.

That Italy and Spain are still offering any positive yield may be enough to keep drawing investors in a world in which a quarter of all investment-grade debt has rates below zero.

Global markets "offer very little return potential, which should mean more investors chase the higher yield and return potential of Italy," said John Taylor, the co-head of European fixed income at Alliance Bernstein.