Fixed Income

The European Bond Markets Today:Be Selective, Be Risk-Aware

By Jørgen Kjærsgaard June 27, 2012

Continued uncertainty and volatility are forcing European bond investors to think on their feet.  But there are ways to generate yield without taking excessive risk. 

For investors with global portfolios, we wouldn’t recommend shunning Europe altogether, but we would advise quite a modest allocation. We think areas of value include euro high-yield corporates, which are priced more attractively than US high yield and offer better credit quality. (The average rating in Europe is one to two notches higher than in the US.)

For investors who focus purely on Europe, it’s important to position the portfolio according to where we are in the market cycle. As a crisis period gives way to the early stages of a rally, that's the time to start building up risk exposure. But we don’t think we’re going to reach that stage for some time. For now, we think return seeking should be tempered by the need to keep overall portfolio risk in check.

We think some of the most attractive opportunities today are in the credit market. This is a time to be an active cherry picker, rather than having passive exposure to the overall market. The broad indices include a lot of issuers in the peripheral countries, as well as cyclical businesses. These types of bonds are offering some very high yield premiums over comparable governments, and they would likely perform well in a rally. But they also tend to be hit harder by bad news and market anxiety. So, in the current environment, we think investors should be more selective about where they seek yield.

Investors who have European-only portfolios might consider a “barbell” strategy for their credit portfolios, focusing on conservative names on one hand and higher-octane names on the other.

Defensive holdings might include assets like covered bonds from financial institutions outside the peripheral region (these are secured by assets, giving investors a high degree of protection). Another example is high-quality nonfinancial corporate bonds issued by robust companies that are based in non-peripheral countries, have high credit ratings (typically single A) and face little imminent risk of downgrade.  

The aggressive side of the portfolio would focus on attractive yields and upside potential (but still steering clear of the peripheral countries). As we discussed a few weeks ago, we see compelling opportunities in euro high yield. Examples include the more robust nonfinancial companies, such as some of the telecommunications providers, which have steady revenue streams and sound business models. As we’ll discuss in a forthcoming blog, we’re also very interested in some of the subordinated financial names outside the peripheral region.

Where else is risk-taking most likely to be rewarded in Europe? We wouldn’t expect interest-rate exposure on its own to be very lucrative this year. Yields of higher-quality government bonds are so low that investors are paid very little to take exposure. And there’s not much scope for further rate falls, so the potential for capital gains is limited and the possibility of losses is rising.

In terms of country selection, much of the market is either risky or expensive. In the peripheral countries, sovereigns are cheap (on average, Italian Treasuries offer yield premium of about 4.6% over German Bunds) and they would likely bounce back well in a recovery scenario. But at this point we feel that the risks in those countries are generally still too high to justify exposure.

By contrast, Bund yields have been forced down so far by safe-haven demand that it’s hard to justify buying them unless you expect a real economic disaster scenario. The Netherlands and Belgium are also expensive, but slightly better value, in our view. French government bonds currently yield quite a good premium—as much as 1.2% more than Germany—but we’re uncomfortable about the uncertainties over France’s economic and fiscal outlook in the aftermath of its recent elections.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

The European Bond Markets Today:Be Selective, Be Risk-Aware
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