Improving prospects for peripheral eurozone bonds

Kommer van Trigt, Robeco's Head of Rates, believes the prospect of enhanced fiscal integration in the eurozone is likely to tempt investors back into peripheral bonds, where yield levels are clearly attractive, during 2012.

In the continued absence of a “bazooka” that would conclusively terminate the eurozone debt crisis, a conservative approach to bonds in the region remains the appropriate stance, says Kommer van Trigt, Robeco's Head of Rates.

Yet even as watchfulness remains the order of the day, the relatively modest proposals for enhanced fiscal integration that are currently on the table should ultimately have a positive effect on the bonds of selected peripheral countries. As the plans gain credibility—after reforms and austerity measures are implemented and when fiscal discipline reasserts itself—investors will look at the wide spreads on peripheral debt in a different light, he feels.

No ‘bazooka’ for eurozone debt crisis
For sure, Van Trigt has been disappointed by the failure of Europe’s politicians to come up with a definitive solution to the crisis. Instead, they have been reactive, resorting to stop-gap proposals that are just enough to stave off the latest episode in the crisis. “We are closely monitoring all the efforts to sort out the crisis but—thus far—have seen little real progress,” he says.

Van Trigt says that three developments would make a real difference. First, a full-scale debt monetization. Second, fiscal integration via euro bonds. Or third, convincing progress on structural reforms and further austerity programs, most notably by Italy.

“These conditions have not been met,” he says. “The December 9 summit offered no truly new measures, but just slightly stronger versions of earlier agreements.”

Brussels summit was another fudge
In many ways, the Brussels summit was just one more fudge. It promised some strengthening of the Stability Pact but not full-scale fiscal integration. The supposedly ‘automatic’ sanctions are still not automatic but are in fact open to political discussion. And the so-called ‘balanced-budget rule’ actually still allows budget deficits.

Furthermore, the ECB has reiterated its reluctance to step into the role as the eurozone’s lender of last resort. “Mario Draghi has been very clear to stress that the ECB will not provide monetary financing for government debt,” says Van Trigt.

In short, Van Trigt does not expect a quick fix for the current eurozone debt crisis to emerge. “We would not be surprised if Europe’s politicians are still struggling with the same issues in a year’s time,” he says. The turmoil is thus set to continue.

Policymakers are committed to saving the euro
And yet. Van Trigt concedes that the picture isn’t as gloomy as it might appear at first glance. For one thing, the new governments in the troubled countries have all announced austerity packages and structural reforms, even though it remains to be seen whether their implementation will be successful.

“Improving growth through structural reforms will be even harder—and will take longer—than cutting budget deficits,” he notes. But this is a positive development.

At the same time, the enhanced fiscal integration that has been set out may not be the “bazooka” that solves the crisis in an instant but it might be a solution that will work in the long run. Naturally, it will take time to prove itself and for market participants to accept it as a credible option. But again, it is a step in the right direction.

A third positive is the determination of Europe’s policymakers to save the euro. It should not be underestimated.

Peripheral governments’ efforts should be recognized
These factors are starting to gain some traction. And, in the light of these positive developments, Van Trigt believes it is time that the northern European hawks cut the peripheral eurozone countries some slack.

“While Germany and the ECB will not immediately take sufficient steps to eliminate the market pressure on these countries, they will have to alleviate it to some degree in order to give these governments a fighting chance to regain the trust of financial markets,” he argues.

Approaching fiscal integration should push investors into peripheral bonds
These developments have important implication for Europe’s bond markets. “The prospect of further fiscal integration—after fiscal discipline has been restored and enshrined—will gradually lure investors back into peripheral bond markets, where yield levels are clearly attractive compared with the core,” says Van Trigt.

As an example, Spanish ten-year bonds are yielding 5.5%, some 3.6 percentage points higher that German Bunds. Meanwhile, the spread on Italy’s ten-year bonds is 6.3 points over the Bund.

Despite such attractive valuations, it isn’t going to be plain sailing for this strategy in 2012. Van Trigt warns that the spreads of bonds issued by the peripheral countries over their German counterparts are set to remain volatile. “We do not expect spreads to be at higher levels by the end of 2012 but—at first—they might move wider,” he cautions.

Overall, though, the resurgence of peripheral bonds should be good news for the performance of the wider eurozone bond market this year. “For EMU government bonds, we expect a return of 5% in 2012,” says Van Trigt.