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Alpha Opportunities in European Fixed Income – Without Adding Risk

Despite European interest rates at historic lows, we believe active investors can still find opportunities in core European fixed income markets. Here we share three potential examples.

With limited prospects for growth and expectations that inflation will continue to run below target, the European Central Bank (ECB) has signaled that policy rates are likely to be anchored at low levels for an extended period of time. As such, European bond yields are expected to remain low for a while.

Faced with the prospects of low or negative yields, European bond investors may conclude that there are no opportunities in European fixed income. We would disagree – European fixed income still offers the benefits that many investors seek from a bond allocation: diversification, capital preservation, and income. The present environment also offers opportunities for active managers to generate enhanced returns through utilizing active yield curve strategies, executing trading ideas derived from deep fundamental research or by using different market tools, such as futures.

Here are three such strategies that we believe may help investors now.

1. Yield curve strategies: Roll down the German curve

Although German Bund yields are at historically low negative levels, they still offer carry (potential return) of about 70 basis points, due to the steep shape of Germany’s yield curve. The Bund curve is steep relative to U.S., Japanese, and UK yield curves, especially between the 5- and 10-year maturities (see chart), and offers the ability to capture a structural source of return. The curve remains steep because the ECB is keeping short rates ultra-low, while the market still requires a premium for longer-maturity bonds. Investors can expect a steep curve to persist as long as ECB monetary policy doesn’t pivot dramatically and the ECB is able to maintain its long-term credibility.

The steepness offers the opportunity to “roll down the curve” – a strategy in which investors buy bonds at a steep point in the curve, benefiting from a price gain as time goes by and yields drop. For example, a 10-year bond will usually have a higher yield (and lower price) than a nine-year security. After one year, the 10-year bond price will increase as its yield decreases to the nine-year maturity point. This process can continue for a number of years, as long as the curve offers sufficient yield pickup between maturities, and also as long as the monetary policy regime does not change. The key for an active manager like PIMCO is to identify any risk of regime shift. At this stage we do not expect a change in regime given the current low growth and inflation backdrop.

The steepness of the German bund curve offers opportunity

2. Tap into overlooked sectors: Danish mortgages

In an aging expansion, characterized by low yields in Europe and tight spreads, we think it is more important than ever to emphasize sectors that provide resiliency and offer attractive risk-adjusted return potential. One example, in our view, is Danish mortgage-backed bonds. This sector has been a regular feature in PIMCO’s actively managed European portfolios because it offers a compelling yield above traditional government bonds, while keeping a low risk profile. Danish mortgage-backed bonds have been around for over 200 years without a single default and offer some of the highest yields in Europe, about 1.5% (euro-denominated), well above other AAA rated assets, most of which yield less than 0% for a similar duration risk.

The source of this additional yield pickup is the option embedded in these bonds: Borrowers have an option to call the bond at par every quarter. This creates uncertainty about the length of the investment, ranging from only a few years if prepayments are high to many years if they are low. This variability is directly linked to changes in interest rates, with prepayments increasing as rates fall and vice versa. In a scenario of stable monetary policy, though, and assuming no change in regime at the ECB, early prepayment should be a relatively low risk, allowing debt holders to invest in high quality assets yielding around 1.5%.

Danish mortgages have been overlooked by passive capital because they aren’t included in traditional bond indices. In our view, for investors able to model and understand prepayment risk, the additional premium provides ample compensation for the incremental risk taken.

Given these fundamentals, we believe Danish mortgage debt could be one of the more attractive European investments on a risk/reward basis.

3. Efficient replication strategies: Futures

As an active fixed income manager, PIMCO seeks to exploit structural inefficiencies in markets. One way to achieve this is by using derivatives – instruments that give exposure to asset classes, but that tend to be far more liquid and flexible than cash bonds (albeit with risks to manage). For example, instead of buying government debt directly, we often use futures, which can be traded in established exchanges, mitigating counterparty risk.

Derivatives can sometimes offer exposure more efficiently than the underlying asset – a mismatch that active managers may exploit. For instance, Bund futures are currently trading at financing levels that are lower than the level where an active manager can invest cash. This could be due to a variety of factors, including supply and demand or investor constraints. By purchasing futures, investors would then have the opportunity to invest the remaining available cash in high quality, short-term instruments with yields that exceed the financing cost of the bond exposure by a currently estimated 20 or 30 basis points (assuming no material increase in risk).

In summary, even in a low yield environment, an allocation to European fixed income may still make sense. Active bond managers have flexibility to tap into opportunities without taking significant added risk.

The Author

Lorenzo Pagani

Portfolio Manager

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PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
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Dublin D02 F721, Ireland
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28046 Madrid, Spain
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75009 Paris

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO