Your clients can’t make a bundle without putting some skin into the game, and that’s especially true for bond investments during the current European sovereign-debt crisis. So, for clients willing to take some risks, bonds from the southern rim of the 17-nation eurozone offer what would, in calmer times, be considered exceptional returns.
For bond inves-tors who see the EU cen-tral banks’ agreement on Nov. 30, 2011, to open virtually unlimited lines of credit to eurozone banks as the beginning of the end of the crisis, the question shifts to how to buy what could turn out to be bargain-priced bonds. As EU banks recover, pressure on governments to back them will ease. Eventually, interest rates on both EU bank bonds and sovereigns will ease, generating large capital gains or allowing investors to lock in high yields.
The numbers read like an all-out bargain sale: Spain’s 10-year sovereign bonds yielded 6.5% at the peak of the crisis in late November but dropped below 6% as signs of the crisis easing appeared with the central banks’ actions on Nov. 30; Italy’s 10-year sovereign bonds’ yields reached as high as 7.56%, then dropped below 6%.
In contrast, 10-year U.S. Treasury bonds pay 2.03% and Government of Canada 10-year bonds yield 2.10% to maturity. But if you want a senior Spanish bank’s bond — say, a five-year Banco Santander SA senior debenture — you can get 11.28%.
A Deutsche Bank AG study of long-term bond returns suggests that if sovereign-bond yields revert to the mean, investors holding 30-year U.S. T-bonds will have to accept annualized losses of 2% a year for the next 10 years. Staying with U.S. T-bonds and the almost parallel-priced Canada bonds for the next decade is a surefire plan to book losses. Thus, the stage is set for a movement of money back to eurozone sovereigns and investment-grade bonds.
The cost of a recovery is less than the cost of allowing the euro currency and banks in the eurozone to collapse. If Germany had to float a new deutschemark, it would rise in value and cut exports that make up 60% of its gross domestic product, much of that sold within the eurozone. Paying dearly for that not to happen is just good economics.
“The cost of fixing the mess is less than the cost of allowing the eurozone and its economies to fail,” says Roger Lister, chief credit officer for financial institutions with DBRS Ltd. in Toronto. “The difficulty now is in getting political agreement of the many parties to the problem.”
Agreement appears to be on the horizon. A Nov. 30 bulletin from the eurozone finance ministers announced movement toward a pact with the International Monetary Fund to work out a bailout of the entire region. Central banks have agreed to provide virtually unlimited liquidity, with the U.S. backstopping the European Central Bank.
The consensus estimate is that the cost of a full bailout would be of the magnitude of one trillion euros ($1.36 trillion). The European Financial Stability Fund and the International Monetary Fund have total assets in excess of that sum. Other central banks will aid in supplying credit to the ECB.
“I believe that the eurozone central banks will do enough eventually,” says Robert Follis, managing director of corporate bond research with Scotia Capital Inc. in Toronto, “to restore the market’s confidence in both sovereign debt and financial services debt markets.”
It is not necessary to buy European sovereign or financial services bonds to await the recovery. Clients can nibble at bonds of U.S. money-centre banks, whose spreads over U.S. sovereign debt have widened in sympathy with those on European banks. In fact, since July 1, 2011, spreads for senior U.S. bank debentures have widened by 300 to 400 basis points, says Vivek Verma, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont.
A Goldman Sachs Group Inc. 10-year note recently has been priced to pay 7.53% to maturity, 550 bps more than the U.S. 10-year T-bond. Goldman Sachs has been through more than a few crises in the past three years, but odds are high that it will get through this and pay its bonds in full. Canadian bond desks trade these bonds, sometimes out of inventory — unlike European bonds, which have to be sourced abroad and are not economical to buy in lots of less than $100,000 or, sometimes, even $1 million.
The safest short-term bet for bond investors remains U.S. T-bonds, Switzerland’s federal bonds and, of course, the debt of well-managed treasuries, such as Canada’s.
The best long-term bet will be a reversion to a form of normalcy, with eurozone bond risk premiums reduced and a substantial reduction in bond yields. Says Chris Kresic, co-lead for fixed-income and partner with Jarislowsky Fraser Ltd. in Toronto: “I share the presumption that the euro will survive.”
There are steps that have to be taken to reduce default risk, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax. Banks have to raise much more capital to satisfy stress tests. That would reduce counterparty risk, to which U.S. banks are exposed. The banks can do this via dilutive stock sales or by selling short-term debt for a few hundred bps over U.S. T-bonds — the most likely outcome.
A good, low-risk bet for playing a European bond recovery would be Wells Fargo & Co., one of the strongest large banks in the U.S., says Marc Stern, vice president and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal.
The Wells Fargo 5.625% issue due Dec. 11, 2017, has recently been priced to yield 3%, about 200 bps more than a five-year U.S. T-bond. That’s not a high-risk bet and, if the counterparty risk that the U.S. banks face declines, this Wells Fargo issue would lose perhaps half its yield premium as its price rises.
So, if you believe that the powers in Europe will be guided by sensible economics, Rogers says, then nibbling at euro-linked bonds from familiar but solid U.S. names makes sense. IE