There’s a bluntness about this one that we kind of like.
Barclays Capital’s AAA Investor note looks at the problems posed by the rally in long-term bonds (sub specie deflationitatis) on Thursday:
These developments pose a problem to most yield-driven real money investors, such as insurance companies and pension funds. 10yr yields are well below 3% not only in Bunds but also in the majority of agency, sub-sovereign supra and covered bond products,which are insufficient to match return targets that generally are close to the 4% mark.
Clearly, faced with a low-yield environment, many asset managers at insurance companies and pension funds focus on further lengthening the duration of their portfolio…
We already have Exhibit A of that — falling ultra-long yields. But as Barcap note:
While this will also help them match the duration of their generally longer-dated liabilities, they will not only struggle to reach their target return, given that in the recent move even 30yr swap rates decreased to 2.90%, but they would also be substantially exposed to potential mark to market in case yields would suddenly back up in a correction move.
In which case — how’s this for a left-field investment strategy, straight out of the European debt crisis (emphasis ours):
An interesting alternative to investments in core government bond and high-quality AAA products at the long end of the yield curve would be to exploit opportunities at the short end of the yield curve. Such opportunities come from European peripheral countries, as only these exposures would comply with the return target…
While this exposes investors to potentially high spread volatility (regularly credit term structures invert in a distressed environment), investors would, in turn, benefit from the fact that the risk of default and/or restructuring is limited through the committed support from the European Financial Stability Facility (EFSF), from the ECB’s Securities Markets Programme (SMP) as well as the fact that a number of sovereigns are well advanced in their funding programmes…
…In order to cope with the strong decrease in yields and the flattening of the yield curve, we recommend investors with return targets of around 4% to explore opportunities in short-dated peripheral covered bonds. These bonds not only offer a significant pick up versus swaps and underlying government bonds, but are also fundamentally protected through various European and domestic support schemes as well as the backing of residential mortgage security.
It’s not crazy. Not crazy at all. We already know there’s a two-tiered market out there in Europe, so may as well put it to work chasing yield. Norway’s sovereign wealth fund is already loading up on peripheral government debt, after all.
And there’s plenty of positions here — government-backed banks, say. But the position overall ain’t going to last, thanks to its key underpinning by the EFSF, which we presume isn’t going to last forever.
After all, as an OECD research paper pointed out on Wednesday, the EFSF is good for a couple of years — then it gets complicated:
Table 5 [above] shows the approximate funding needs of Italy, Spain, Greece, Ireland and Portugal based on simulations using OECD growth and deficit forecasts. The EFSF could more than cover all of the funding needs of these countries, even in the unlikely case that no securities could be sold on the open market, for the period of the stress test (2009-2011). So the assumption of no default over this short period is reasonable.
The concerns in the market beyond 2012 are: the longer-run fiscal sustainability problem; and the difficulty of achieving structural adjustments in labour and pension markets needed to ensure sustainable growth in a period of budget restraint. The fear is that this will not be resolved by the time the support packages run out, and hence the probability of restructuring may not be put at zero by portfolio managers.
Complicated — but not hopeless. The paper’s authors suggest that the EFSF would have the potential to be much more useful than its original bailout purpose, for the time it does operate (emphasis ours):
Figure 3 [above, click to enlarge] shows a simple stylised picture of how the SPV could work to help meet government financing needs, while also reducing the sovereign bond exposures in the banking sector. If a bank with a hypothetical balance sheet of €100 holds a €10 sovereign bond of a fiscally-exposed country, and its duration is less than the 3 years life of the SPV, then it can simply let the debt roll off its banking book without re-financing it. The funding gap for the government concerned would be met by a direct €10 loan from the SPV, which would raise €10 of European-wide guaranteed SPV bonds. The bank could bid for these SPV bonds—thereby essentially exchanging sovereign debt for higher quality (though lower returning) SPV assets. Alternatively, the bank could de-lever (let its balance sheet fall); or lend (helping the economy). Some other entity would buy the SPV bonds (e.g. sovereign wealth funds, pension funds etc). Regardless, in this example, sovereign risk is transferred from the bank’s balance sheet to the public sector’s balance sheet.
On that last point — Willem Buiter has previously observed that the SMP could achieve the same end, too. Of course, if risk is transferred in this way, the eurozone and its peripheral sovereigns still look like a fiscal mess in any case.
But, when the pale horseman of global deflation — deflation that could last well beyond the EFSF’s lifetime — is on the march, we’d bet investors will do surprising things for yield.
Related links:
Ireland shakes, rattles and rolls – FT Alphaville
The unsecured vs covered bond anathema – FT Alphaville
Sovereign/Securitisation/Stop – FT Alphaville