AllianceBernstein: Sovereigns offer value on Europe’s periphery
Jorgen Kjaersgaard, head of European Credit Portfolio Management, and John Taylor, portfolio manager of Multi Sector, both at AllianceBernstein London, argue that peripheral sovereign bonds offer better value than corporate bonds.
Investment-grade bonds issued by nonfinancial firms in Europe’s peripheral countries have had a great run but now look expensive. In our view, government bonds from the likes of Spain and Italy offer better value for investors who want peripheral exposure.
A few years ago, Europe’s debt crisis prompted investors to ditch both peripheral corporate and peripheral sovereign bonds, sending their yields soaring. More recently, with the economy on the mend and interest rates at record lows, investors eager to boost their returns have rediscovered their taste for peripheral assets.
To be fair, low global interest rates have investors around the world thirsting for yield. But efforts to slake that thirst have been especially determined in Europe, where the 10-year German bund yield-the risk-free rate against which other rates of return are compared-is just 1.46%, more than a percentage point below yields on comparable US Treasury bonds.
That has sent investors charging back into bonds issued by companies from Europe’s periphery, causing a sharp decline in yield spreads. In mid-2012, nonfinancial investment-grade bonds from Portugal, Italy, Ireland, Greece and Spain yielded 4.7% more than comparable German bunds. At the end of April, that spread had tumbled to a slender 1.05%-just marginally above the 0.96% pickup available on higher-rated corporates from Europe’s core countries (Display).
Things have worked out for those who got in early enough to benefit from that rapid slide in spreads. But tight spreads mean that it’s now a lot harder to make money. Squeezing more return out of peripheral corporates at this point may be a losing battle. And if investors should sour on these assets, there’s plenty of room for them to underperform.
With value harder to find in corporate bonds, we think peripheral sovereigns-especially medium- and long-term bonds-may offer a more attractive value proposition.
That statement may raise a few eyebrows. After all, it was peripheral government bonds that investors couldn’t ditch fast enough during the darkest days of the debt crisis. It’s also true that yields on peripheral government bonds have retreated from the highs they hit in the midst of the crisis.
But unlike with investment-grade peripheral corporates, the yield and spreads on long sovereigns are still considerably higher than those on shorter-dated bonds. That means investors have the potential to boost returns while assuming less credit risk than they would on similar-maturity corporate debt.
Spanish and Italian 30-year bonds in particular offer an attractive yield pickup over German bunds. They’ve also historically been less volatile during periods of crisis than 10-year bonds-a nice insurance policy should market sentiment in Europe deteriorate.
And investors on average aren’t giving up credit quality for the higher yields on sovereign bonds. Their ratings today are in line with those on corporate bonds. In fact, the average ratings on investment-grade peripheral credits have deteriorated as the premium for buying them has vanished. In mid-2012, they hovered between A- and BBB+. Today, they toe the line between BBB+ and BBB, the same as sovereigns.
Some investors might be tempted to bypass both sovereign and investment-grade bonds by reaching even further down the credit spectrum. In our view, this can be tricky when it comes to the peripheral countries. Here too, high demand has driven down yields to the point where even many CCC-rated “junk” bonds are yielding less than 5%.
Again, investors must consider whether they’re being compensated for the risk. The peripheral countries are recovering but still face stiff economic challenges. Therefore, buying high-yield bonds from companies based on the periphery demands extensive credit research-the kind we fear is often overlooked in the rush for yield.
We’re confident that Europe, despite its challenges, has turned a corner, and we expect the economy to gain momentum as recovery broadens. But fixed-income investors should likewise broaden their horizons and consider a multisector approach that embraces value as well as yield.