Bond Buyers Beware: Bund’s premium irrational with Eurozone moving beyond crisis point
Too much longevity in ECB’ QE program may have been priced into Eurozone’s safest long-dated bonds as sub-zero inflation linked bond yields of Germany suggest unrealistic ‘crisis like’ conditions. The re-leveraging of banks’ balance sheets suggests a departure of government debt hoarding and the return of more risk-taking behavior as bank credit growth put a domestic demand-led recovery on a more solid footing. The bond market in Europe looks increasingly vulnerable to more volatility. At the epicentre of souring sentiment are Bunds. This, not Greece, is dictating the direction of bond yields elsewhere in Eurozone bond markets. Bearish position in Eurozone fixed income may be warranted. Leveraged short ETPs tracking German Bunds and Italian BTPs are efficient investments to play the theme The macro backdrop for fixed income has turned decisively more bearish with solid jobs data from the US suggesting a rate hike as early as September even while the prolonged standoff between Greece and its international lenders is keeping the ‘Grexit’ theme alive. But these drivers are unlikely to be the main triggers for the souring sentiment in what is arguably the safest safe haven: German Bunds.
Bunds priced as though Eurozone remains in crisis-mode
Draghi’s comment must have been a wakeup call for investor when at the peak of their valuations in April, German government yields hovered just barely above zero percent for the 10-year Bund. The opportunity of the German government to issue Federal notes with 5 year maturity with a zero percent coupon since the start of the year shows how lopsided the credit market in Europe has become in favor of debtors and at the expense of creditors. Following the marked sell-off last month, the 10 year yield on Bunds climbed steeply to 1% even as its implied volatility hit 9%, levels not seen since mid-2011 (see Chart 1).
A better indication of potential significant mispricing in German debt is in its long dated inflation-linked securities (ILS) and the crisis-like yields these offer investors. Because with German’s 10-year real yields hitting a negative 1.38%, an investment in ILS only makes sense if investors forecast a decade of depression-like economic conditions for the Eurozone. Until last year this was justifiably the biggest concern. But after a series of exceptionally stimulus policies resulted in sub-zero policy rates, TLTROs and QE we are in all likelihood well past that point. And yet even after the violent correction, the fear premium paid for Bunds by investors has not entirely gone away. The real yield on German 10 year ILS continues to hover in negative territory which, at -50 bps, fundamentally suggests a decade of economic contraction.
While the ECB QE program is distorting the fundamental picture in secondary markets, there is visible evidence of more pronounced souring investor sentiment in primary markets, in particular for the very long dated Bunds. On its most recent issue of 30-year maturities by the German government on 28 January this year, it allotted only EUR 939 million after receiving bids of EUR 1.2 billion, the lowest on record and underscoring the fact that the Bunds’ 30-year issues average bid-to-cover ratios of since 2014 have markedly undershot the long-run historic average of 1.5.
Banks re-leveraging balance sheets marks an end to years of risk-aversion and signals confidence and strength
The nominal low and negative real long term yields of German bunds become hard to justify when there is growing evidence that the Eurozone has moved passed its crisis point. Eurozone’s banking sector has successfully restructured and undergone equity recapitalisations, particularly in Italy and Spain. More still needs to done, in particular with respect to the consolidation in Italy’s overbanked industry and the restructuring of delinquent loans in Spain. But overall, the bad banks created have made Eurozone banks’ balance sheets transparent. In fact, Evidence of Eurozone banks gaining strength is the expansion of loan books. For instance, since 2014, the deleveraging of bank balance sheets reversed, with private sector loans growing by EUR 95bn (to April 2015), an indication that banks see extending new business loans offering increasingly better risk adjusted returns as a viable alternative to hoarding government debt.
Efficient bearish positioning in fixed income with geared short ETPS
Greece is unlikely to have anything much to do with the recent sell-off in Bunds. Shut out from ECB QE support, the yields of Greek government debt have hit default levels well before QE was implemented and its steady climb since has not reverberated on Portuguese, Spanish or Italian government bonds. Instead, these have moved in lockstep with German Bunds and since the turbulence in bond markets started in May have also become more sensitive. For instance, the 10 year spread of Italian BTPs over German Bunds has risen from 90 bps in the end of March to 140 bps today.
There remains a real case for bearishness in Europe’s bond markets even after the recent correction. A potential opportunity presents itself for investors to short government debt in Europe. Investors sharing this sentiment may consider the following short ETPs:
All data is sourced from WisdomTree Europe and Bloomberg, unless otherwise stated.
WisdomTree Europe Ltd is an appointed representative of Mirabella Financial Services LLP which is authorised and regulated by the Financial Conduct Authority. The value of an investment in ETPs may go down as well as up and past performance is not a reliable indicator of future performance. An investment in ETPs is dependent on the performance of the underlying index, less costs, but it is not expected to match that performance precisely. ETPs involve numerous risks including among others, general market risks relating to the relevant underlying index, credit risks on the provider of index swaps utilised in the ETP, exchange rate risks, interest rate risks, inflationary risks, liquidity risks and legal and regulatory risks. ETPs offering daily leveraged or daily short exposures (“Leveraged ETPs”) are products which feature specific risks that prospective investors should understand before investing in them. Higher volatility of the underlying indices and holding periods longer than a day may have an adverse impact on the performance of Leveraged ETPs. As such, Leveraged ETPs are intended for financially sophisticated investors who wish to take a short term view on the underlying indices. As a consequence, WisdomTree Europe Ltd is not promoting or marketing BOOST ETPs to Retail Clients. Investors should refer to the section entitled "Risk Factors" and “Economic Overview of the ETP Securities” in the Prospectus for further details of these and other risks associated with an investment in Leveraged ETPs and consult their financial advisors as needed. Within the United Kingdom, this document is only made available to professional clients and eligible counterparties as defined by the FCA. Under no circumstances should this document be forwarded to anyone in the United Kingdom who is not a professional client or eligible counterparty as defined by the FCA.This marketing information is intended for professional clients & sophisticated investors (as defined in the glossary of the FCA Handbook) only. This marketing information is derived from information generally available to the public from sources believed to be reliable although WisdomTree Europe Ltd does not warrant the accuracy or completeness of such information. All registered trademarks referred to herein have been licensed for use. None of the products discussed above are sponsored, endorsed, sold or promoted by any registered trademark owner and such owners make no representation or warranty regarding the advisability on dealing in any of the ETPs.