Substitution and diversification: The appeal of short duration bonds in Europe
Despite the current headwinds in Europe, a recession for the eurozone in 2015 is unlikely.
Growth and inflation across the region are more likely to oscillate around zero than sharply deteriorate. General consensus on the base-case scenario for the end of 2015 sees the eurozone economy remaining more or less where it is now, not really growing or shrinking much. Given structural constraints, growth is likely to be limited to the region’s trend rate, somewhere between 1% and 2%. Inflation should be weak in the first part of the year with higher prints towards Q4 as the year on year oil price decline drops out. The QE programme in Europe should serve to anchor in the short end of the yield curve for the time being.
Against this backdrop, diversified short duration bond funds offer an attractive opportunity for investors currently facing negative yields from short-term government bonds and cash investments in much of Europe. Investors looking for another home for these investments, yet without taking on significant interest rate risk in longer-dated bonds, will need to look further down the credit spectrum – and away from risk free assets – if they are to find higher yields.
Given the high historic dispersion in the performance of European sovereign bonds, there are opportunities among high-quality, shorter-maturity debt to maximise returns by exploiting yield differentials, sometimes resulting from market volatility.
The opportunity to capture return through country allocation within Europe is illustrated by the yield differential between Italian and German sovereign bonds which, despite the significant narrowing of spreads that has occurred since mid-2012, still appears attractive. Although the yields on Italy’s bonds have come down a long way since then, they do not yet seem to have fully discounted the potential benefits from structural changes that are occurring (albeit haltingly) in the country’s economy. Meanwhile yields on German Bunds continue to build in a “safe haven” premium which to many will seem unmerited.
Another area for potential yield pickup is the use of allocations to corporate credit. Many issuers remain potentially attractive relative to the comparable-maturity sovereign debt of several European countries. In addition, many companies are benefiting from improved balance sheets and lower interest costs are supportive of this.
While not part of the ECB’s asset-purchase plan, corporate debt should still do quite well from the program. With the ECB buying up large quantities of sovereign bonds, it is likely that demand for corporates will increase over time as investors search for positive yield and that may lead corporate spreads to continue to compress.
As investors move down the risk spectrum to substitute higher yielding bonds for negative yielding ones, the key will be to retain a strong level of diversification in their portfolios with allocations to a multitude of corporate and sovereign bonds. This is an important advantage in today’s volatile markets.
David Zahn is head of European Fixed Income at Franklin Templeton Investments