No value play in European bonds

By Vikram Barhat | November 28, 2011 | Last updated on November 28, 2011
3 min read

The European bond market is bracing for a rough week during which Belgium, Italy, Spain and France will be auctioning their debts. The timing couldn’t be worse. Just last week, in its worst-ever auction, Germany failed to find buyers for about 40% of its €6 billion offering of 10-year bunds.

It doesn’t bode well for the European bond market if the strongest nation in Europe is struggling to raise capital. The German bond auction is indicative of the general weakness in Europe, says Jamie Price, director of fixed income for Macquarie Private Wealth Canada.

“For international buyers, the prospect of buying 10-year German bunds at around 2% and staying in euros is a pretty risky bet because if Germany drifts towards [supporting] a eurobond system or decides to fund a greater financial stability platform, [it could] increase the cost of funds substantially,” he says.

The only downside with the bund market comes from the fact they are denominated in euros, which makes contagion a problem.

“International bond managers, if they are worried about the euro, are going to be getting out of them,” says Price. “It doesn’t necessarily make the promise of repayments of bunds any less certain than it was before, but if your going to add an average cost of funding across the eurozone, which is what a eurobond would likely do, Germany’s cost is going to go up.”

The best bet for would-be bund investors could be to just sit back and wait to see if the Eurobond materializes. If it does, the investor could get a substantially higher yield on the bund.

Despite being doggedly opposed to the Eurobond solution, Germany seems to be drifting towards it. “[The eurobond] still seems to be on the table and that leaves the upside for German bunds pretty limited,” says Price.

But he denies that German bonds are tainted by the rest of the continent. “I don’t think they are necessarily tainted; their economic fundamentals are reasonably strong and we put them in the same camp as the government of Canada and other AAA issuers that we’re very comfortable with.”

Similar views are offered by Joey Mack, director, fixed income, GMP Securities. “Fiscal unity [in the Eurozone] will mean, de facto, Germans will be funding the rest of Europe. That means their credit quality deteriorates and their borrowing costs go up, so the impact [of eurobonds] is going to be negative,” he said.

Germany is not going to take that lying down, says Mack, adding that it would take some form of constitutional change around their fiscal responsibility. “I can’t see German voters approving that.”

Buying bunds now is as much a play on the euro as it is on Germany. Broadly speaking, there’s very little value in Germany. It’s been the refuge for a considerable flight to quality for investors determined to maintain a euro-exposure. That has compressed the bund’s yield, squeezing any remaining value out.

On a relative basis, France offers better value than Germany, said Mack who wouldn’t recommend investors buy German bonds.

“They are expensive right now on that whole flight to quality theme over the last several months,” he says. “From the Canadian perspective I don’t necessarily like the euro at this level.”

Vikram Barhat