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Euro bonds in a post QE world

These days, conventional bonds are providing very little shelter from equity volatility, complicating asset allocation decisions once again. So what’s next for euro bonds? Philippe Baché, Head of Fixed Income at Lyxor ETF, shares his views

Recent market stress has suppressed core euro government bond yields once again. 10-year bund yields are back below 0.2% for the first time since late 2016 – an unattractive level and a valuation that’s overly sensitive to rate moves.

But beyond that short-term stress, the ECB’s policy path and the identity of Mario Draghi’s successor are the issues that will be on investors’ minds in the new, post QE world. The elimination of negative interest rates and the provision of liquidity to the banking system are the major priorities – with another Targeted Long-term Refinancing Operation (TLTRO) on the horizon it’s clear the bank can’t yet abandon stimulus entirely.

Offering unlimited funding to all banks could however result in a material expansion of the bank’s balance sheet, which would seem odd given it’s just concluded its QE programme. A generous TLTRO could also delay a rate hike. For now, we still expect the ECB to deliver just one, minimal hike of 10 basis points in September 2019 – just prior to Draghi’s departure – but any slowdown in the economy could push that out even further. Like Lorenzo Bini Smaghi, our Chairman and a former ECB banker, we expect little in the way of change from his, as yet unknown, successor. 

Pockets of opportunity on the periphery

Prudence is the watchword for the ECB, given the economic uncertainties. Draghi’s doves should sustain the hunt for yield, so we still see value in peripheral bonds, but it won’t necessarily be an easy ride. We’ll be watching out for any sign of more tension in Italy in particular.

So far, this year’s new issuance has met with solid investor demand but we do expect some volatility after the European elections in May. The EC will have to react to the results of the Italian government’s latest Stability Programme, and if there are no improvements to be seen in the country’s debt and growth prospects, then the question of an EC procedure against it will be back on the table. For now, country spreads look to be a good place to earn yield and carry. 

A high yield haven?

That search for yield should also encourage investors to prefer corporate bonds to sovereigns. Bank lending to non-financial corporates is gaining traction and there is no sign of a tightening in financial conditions anywhere outside of Italy. The ECB is far likelier to relax policy again.  

Default rates should fall in early 2019, as they have in the US, and they remain well below historical averages. Low funding costs and relatively low levels of balance sheet leverage don’t mean companies won’t default, but they do mean that the lag between defaults and growth will probably be longer compared to previous years. The peak of defaults in this cycle may well come in 2020-2021.

Meanwhile, the spread between high yield and investment-grade debt is back to “normal” (or at least its average since 2012).  On this basis, we prefer high yield given its higher carry, but it’s still important to be selective.

Explore our euro high yield range

Innovation in inflation

We’re still positive on inflation-linked assets, although the Q4 2018 collapse in oil prices has had an indirect effect on inflation term premia and growth expectations. Even if inflation expectations don’t pick up, we should see greater demand for linkers as a carry trade given their attractive yield advantage over nominal bonds.

As it did in early 2018, liquidity could improve in the early part of this year as supply comes to the market. If the first January auctions are anything to go by, interest is strong. All in all, it could be worth considering using some more innovative fixed income strategies to bolster your bond portfolio. 

Investigate our inflation range

Discover our ETFs

Source: All data, views & opinions Lyxor International Asset Management & Bloomberg as at 31 Jan 2019 unless otherwise stated. Past performance is not a reliable indicator of future results.


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