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Investors in European bonds are heading into this rate-hike cycle more vulnerable than they’ve ever been before, suggesting that the painful selloff of recent weeks could be only the beginning.
Bonds have tumbled this month as the highest inflation in decades spurs traders and bank analysts to outdo each other in betting on ever more hikes from the Federal Reserve and European Central Bank. The latter is now seen taking its key rate back to 0% this year.
Even though ECB chief Christine Lagarde has tried to push back on expectations for the euro zone, sharp moves in long maturity debt from Germany to the likes of Deutsche Bahn AG and Nestle SA are bringing into question the “haven” status of these securities.
The driving force behind this is a metric known as duration — a measure of the sensitivity of bonds to rate hikes. That’s jumped after years of cheap borrowing costs and vast liquidity led borrowers to take advantage by extending their maturities.
For European government bonds it’s now 8.27 years, more than two years higher than the last time the European Central Bank hiked rates in July 2011, according to Bloomberg index data. The corresponding figure for euro high-grade corporate debt is a year higher at 5.13 years.
“As of now, it’s the front-end that has suffered the most in the recent selloff,” said John Taylor, a portfolio manager at AllianceBernstein who manages $5.4 billion of funds. “As the focus shifts to the impact of quantitative tightening, the market price will start to price in more of a term premium for longer term debt in the 10s and 30s.”
Taylor’s funds are increasing cash and other floating rate instruments that are removed from rates and credit market volatility. A key gauge of expected price swings for the bond market — one-year options on two-year volatility — rose to the highest level since 2011 this week. “There isn’t a safe haven right now. So staying out of the market for the next month or two isn’t the worst thing,” he said.
Reflecting Taylor’s sentiment, the cash glut in the euro-area economy rose to a record above 4.5 trillion euros ($5.1 billion) this month.
Amundi SA, Europe’s biggest fund manager, has also sounded a warning. In a recent note, the firm recommended that investors maintain a short duration bias since traditional bond benchmarks face the challenges of low yields and high duration risk.
While the rates and investment-grade debt markets are usually the first in line of fire during a hiking cycle, the increase in duration means that this time could be particularly brutal.
“All the assets that have benefited from the extraordinary stimulus have higher duration now and are vulnerable,” said Pierre Verle, a high-yield debt portfolio manager at Carmignac Gestion SA, with $1.5 billion of assets under his purview.
Within credit, floating-rate notes and junk debt can offer a way to reduce duration risk. Patrick Armstrong, chief investment officer at Plurimi Wealth LLP, prefers high-yield bonds to German bunds or U.S. Treasuries, he said in a recent Bloomberg TV interview, particularly since default risk remains low. A Bloomberg index tracking euro high-yield notes had a duration of 3.8 years as of Feb. 11.
Some investors are looking even further afield. According to Carmignac’s Verle, clients are putting money into private equity, venture capital and real estate to reduce exposure to interest rates — though these asset classes are also sensitive to rate hikes, even if the immediate impact is not obvious, he said.
For Philipp Burckhardt, fixed income manager and strategist at Lombard Odier Investment Managers, the best approach is to take on a combination of duration and credit risk. The firm sees fallen angel bonds, which are those demoted to junk from investment grade, as a sweet spot.
“At the end of the day, everyone needs yield — and to deliver that you need a combination,” he said.
Next Week
Investors will be watching another large weekly line up of ECB speakers for further clues next week, including Lagarde and Chief Economist Philip Lane.
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Euro-area and German economic figures are light on the ground with February ZEW the only number of note. The agenda in the U.K. is busier and headlined by January inflation and retail sales.
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Euro-area bond sales from Germany, the Netherlands, France and Spain are expected to total 33 billion euros ($37.6 billion). The U.K. sells 2.25 billion pounds of 10-year bonds.
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