Significant bond trading profits await clients whose financial advisors have positioned them to capitalize on the possible abandonment of the euro. Prices of German bunds and the sovereign debt of other European countries with strong credit ratings have soared while yields have plummeted as speculation increases that the euro will ultimately cease to exist.
Consensus is building that restored German deutsche marks, French francs and Dutch guilders would reward investors. That explains why 10-year German bunds yielded 1.23% and two-year German bunds yielded negative 0.06% on July 16. Both sets of bunds are close to all-time lows, Bloomberg LP reports, and are yielding less than Germany’s current inflation rate of 2.2%.
“Buyers are shoring up their accounts,” suggests Camilla Sutton, chief currency strategist with Bank of Nova Scotia in Toronto, “in expectation of currency moves sufficient to cover the inflation gap.”
As Caroline Nalbantoglu, president of CNal Financial Planning Inc. in Montreal, explains: “The income loss on these bonds could be made up by a capital gain if the eurozone breaks up and Germany’s and other superior bonds gain even more value.”
In effect, it amounts to a conventional trade in which you would buy a low-dividend stock that appears undervalued.
The move to German bunds is not isolated. Buying into superior debt issues also is cutting the yields of top-ranked European national bond issuers. On July 16, France’s five-year state bonds saw their yield drop to 0.95% after reaching a record of 0.888%. The Netherlands’ two-year bond also saw its yield drop to 0.016%, also close to its record low.
In contrast, credit-challenged bonds are sinking, making the flight to German bunds and other superior sovereigns more appealing. In the third week of July, Spain’s 10-year sovereign bonds yielded 6.74%; Italy’s sovereign bonds, 6.01%, and Portugal’s, 11.4%. State bonds from Europe’s basket case, Greece, paid 28.45%. (However, Greece’s rates are theoretical, as bids are absent and credit markets have seized up.)
These high rates are not sustainable, says Fergus McCormick, senior vice president and head of sovereign ratings with DBRS Ltd. in New York: “What is happening to the PIIGS [Portugal, Italy, Ireland, Greece and Spain] is trickling down to the corporate market. In Spain, corporate issuers are on the sidelines.”
Spain’s bond market has a case of rigor mortis. The worries about Spain, the crisis country of the moment, extend to related bonds that pay in U.S. dollars.
In fact, a proposal by Catalonia’s government to sell 26 buildings for 450 million euros – with the stipulation that rents would be paid in US$ if the euro becomes defunct – has been put on hold because a potential bidder refused to buy even bricks and mortar in southern Europe.
There are two ways to play the potential abandonment of the euro. If your clients are willing to take on both currency and default risk, they can buy into the sovereign bonds of Spain or Italy at their astonishing interest rates and hope that outstanding PIIGS sovereign bonds will command premium prices whether the euro disappears or not.
This is a strategy based on the idea that things will not be as bad in the end as the market appears to predict. It is a complex and dangerous gamble. If issuers were to reprice euro-denominated bonds in new currencies to take away the premium of this bottom-feeding strategy, speculators would be crushed.
The second strategy, one more appealing to conservative advisors and their clients, is to shun risk. So, you could rush to safe-haven bets in German sovereign debt, bypassing riskier trades in PIIGS’ and other challenged countries’ sovereign and even corporate debt.
“We would be very cautious about buying euro bonds, even with alternative pay currencies,” says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax. “If an issuer can’t get financing in his home market, then issuing abroad raises a lot of worries.”
The reality of a potential euro-zone monetary breakup is becoming more credible as the monetary crisis continues. In Frankfurt, the bond markets are functioning. Other markets, in which bids are hard to come by, are on hold. That already is a contradiction of the idea that the eurozone would be a unified market.
There also are carry-over effects, for although German companies can get bank or bond financing at rock-bottom rates, competitors in Italy and Spain have trouble getting money and have to pay dearly for it. So, on a trade basis, the credit crisis is likely to get worse.
Greece’s national debt, at 360 billion euros, was a small matter compared with Spain’s national debt of 740 billion euros and Italy’s national debt of 2.3 trillion euros. If the European Central Bank pumps up economies with freshly printed money and debt issues, it risks severe inflation, which would be a tax on money itself. If authorities do nothing, they risk bank collapses. With one currency, bonds will take the heat or reap the rewards that independent currencies would have had in the past.
The crisis in the one currency world of the euro will not be resolved anytime soon. The eurozone countries are democracies, with the potential to drag any debates about numbers into the streets. Thus, the future of euro-denominated bonds rests squarely on a speculative guess regarding whether numbers or mobs will rule. That’s why those who usually invest in most of the troubled countries’ debt are watching but not trading.
While you and your clients are waiting for clarity, you can take positions in German bunds or, as trading alternatives, French or Dutch bonds. The cost is forgone interest, compared with the 0.98% on two-year Canadas or the 1.66% that 10-year Canadas pay. But the gain, if the euro does go the way of the dodo bird, would most likely be a substantial currency gain – foremost in German bunds but also in other strong credits.
Thus, the game is no longer just about profits; it’s about insurance from currency mayhem as well.
© 2012 Investment Executive. All rights reserved.