With core euro area bond yields hovering at very low levels and hence delivering mediocre expected returns, investors have turned to higher-yielding instruments, namely corporate and non-core euro area government bonds.
This week, we explore potential opportunities in non-core government bond markets to generate higher returns. We already made a case for Spanish bonds as a clear overweight to German government instruments, while expressing reservations about Italian bonds. As the euro area will have to contend with lower growth rates, our main focus continues to center on issuers which have implemented policies that will support sustained structural improvement. Although Italy has the highest yields apart from Greece, we still have reservations as the policies of the current government do not address the structural deficiencies.
Ireland, Spain and Portugal suffered severely during the financial crisis as the credit-inflated bubble burst. All three countries had to undergo painful adjustment processes during the euro crisis in 2012, resulting in a significant improvement in fundamentals. From a valuation perspective, however, Portugal looks too expensive, leaving us with the next two higher-yielding markets: Spain and Ireland.
The progress achieved by Ireland and Spain since the global financial crisis is most visible in clear improvements in their current account balances. Ireland shines with a significant reduction in overall government debt/GDP levels and strong GDP growth. The improving credit profile should make Ireland a candidate for a rating upgrade. Spain is clearly the strongest of the peripheral countries, having implemented meaningful structural reforms that have led to above-average GDP growth.
Spread levels for the two countries are tight by historical standards. They reflect the structural improvement of the countries as well as the extraordinary support by the European Central Bank in the form of asset purchases and ultra-low interest rates. In Spain, the minority government failed to pass the budget and is likely to face new elections. We believe this will result in a center-right coalition that will continue the current fiscal consolidation so we do not expect a significant impact on performance.
In Ireland, a “hard Brexit” would have a more serious impact on the growth outlook, given its close economic ties with the United Kingdom. Roughly 12 percent of Irish exports are destined for the UK, and as such, an “uncontrolled Brexit” would have negative short-term effects on Irish bonds. The spread to Germany has already widened by 50 basis points since the lows registered in October 2017 and we expect the spread to widen more in the short term as Brexit negotiations near the endgame.
We find that Spain and Ireland are the most promising of the non-core bond markets. Both countries have implemented policies that have led to significant structural improvements. They offer higher yields and steeper yield curves than core euro bond markets and should generate significantly better returns over a 12-month horizon. With Brexit negotiations heating up until the March deadline, we expect Irish bonds to underperform in the short term so we would wait for a better entry point. Spanish bonds continue to be our preferred market in the non-core space.
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