Fixed Income Blog

Identifying Catalysts for Change in European Bond Markets

22 October 2019

4 min read

John Taylor| Head—European Fixed Income; Director—Global Multi-Sector

European bond investors are facing a quandary, with yields seemingly anchored at low levels but more price volatility likely. In this environment, we’re seeking catalysts for buying opportunities in a tricky market.

Monetary policy and macroeconomic forces have created complicated conditions for investors in European fixed-income markets. Eurozone government bond yields have fallen a long way, but with the European Central Bank (ECB) extending its quantitative easing (QE) programme and pushing rates further into negative territory, it’s hard to see a trigger for a sustained move higher. Meanwhile, economic growth is losing momentum. We have already lowered our global forecasts and think that growth could decelerate further.

Trade tensions and deglobalization will likely continue to weigh on sentiment. In this increasingly complex situation, markets have become highly sensitive to news flow on macroeconomics, politics and trade tensions. As a result, we expect sharp moves between optimistic “risk-on” and pessimistic “risk-off” market phases.

Long Duration Looks Less Attractive

Since 2012, long-duration strategies have performed well, supported by ECB policy. But following the recent rally that was triggered by the resumption of ECB easing plans, we believe these gains from long interest-rate risk have largely played out. In our view, the balance of risk and reward is shifting away from a scenario of ever-lower rates and continuing gains for long-duration positions. Investors have to think differently to seek their returns.

The ECB’s insistent calls for fiscal policy stimulus indicate that it has limited scope for further rate cuts and that additional QE cannot be relied on to kick-start growth. That’s not to say that the era of ultra-low yields is over. We believe the probability of concerted euro-area government spending increases is low, and correspondingly the risk is slight that euro-area government bond yields will switch to a permanent rising bias. But we think there is more to gain now from a nimble approach that can identify the catalysts for change between risk-on and risk-off regimes and dynamically manage portfolio positions accordingly.

Focus on Higher Quality Credit

Some parts of the market look especially vulnerable today. For example, a combination of low and flagging growth plus possible trade and political shocks is potentially very adverse for the riskier end of the high-yield (HY) market such as CCC rated bonds. By contrast, despite optically low yields (Display below), higher credit quality bonds look relatively attractive at current levels in the context of expected lower growth.

Risk Markets Remain Too Complacent About Economic Slowdown Risks

Portfolios Need to Be Re-Anchored with More Balanced Exposures

As of October 16, 2019
For Illustrative purposes only
Source: Bloomberg

For example, global IG (investment grade) bonds offer both relatively stable returns and a positive yield. Although IG spreads are modest relative to historical standards, they still mostly offer positive income as opposed to negative yields across most euro-area government bond issues. That’s an enticing prospect for risk-averse investors hungry for any little bit of yield. And while lower-rated credits have much higher spreads, they come with prospectively high volatility too. Investors should be wary of overexposure to the lowest-rated parts of the HY market and opt for a more balanced credit exposure that can give more protection against drawdowns, in our view. At the same time, the disparity in valuations will likely present good opportunities for nimble investors alert to catalysts for changes in the market mood.

Potential Catalysts

Catalysts could arise from unexpected sources, but a few example scenarios stand out.

A certain amount of Brexit risk is already priced into UK markets. A disappointing “hard-Brexit” outcome would likely result in further price falls and some good buying opportunities, particularly in bonds issued by UK banks. After a long period of de-risking their businesses and rebuilding their balance sheets, UK banks are relatively resilient to shocks, and if their bonds’ spreads were to widen in a hard-Brexit scenario, they would represent attractive value, in our view.

Meaningful increases in government bond yields, driven by expectations of impactful fiscal policy would be a strong buy signal. That’s because we believe the chances of effective fiscal stimulus are low and the euro-area economy is unlikely to rebound quickly. Wider IG spreads would look very attractive too.

The less we hear on the political side in Italy, the more likely it is that longer-dated spreads and yields on Italian Government bonds continue to move lower. Shorter-dated Italian Government bonds are now unattractive, generally yielding less than better-rated corporate bonds. However, the longer maturity part of the market remains somewhat cheap ahead of the ECB restarting purchases next month, and with Italy having issued a US$7.5 billion multi-tranche deal in USD this month, further reducing their domestic supply needs.

As we move towards year-end, we think the chances of a risk-off phase are rising. Brexit, US-China trade tensions and the Middle East could all be catalysts, at a time when liquidity is dwindling ahead of the winter holiday period and when central banks have already used most of their ammunition. That unappealing combination of factors could create significant value for nimble and well-prepared investors, using a dynamic investment approach that aims to deliver positive returns while protecting against big drawdowns.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

About the Author

John Taylor

John Taylor is Head of European Fixed Income and Director of Global Multi-Sector at AB. He is a senior member of the Global Fixed Income, UK and European Fixed Income, and Absolute Return portfolio-management teams. Prior to this, Taylor was responsible for the management of single-currency portfolios. He joined the firm in 1999 as a fixed-income trader and was named in Financial News’s 40 Under 40 Rising Stars in Asset Management in 2012. Taylor holds a BSc (Hons) in economics from the University of Kent. Location: London

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Identifying Catalysts for Change in European Bond Markets

Long Duration Looks Less Attractive

Focus on Higher Quality Credit

Potential Catalysts

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