Peripheral bonds: How to play Europe’s recovery
Investors confident in Europe's upturn should consider purchasing bonds from the region's struggling peripheral countries, as well as seeking value in its stock market, euro zone analysts said.
Research from Barclays on Wednesday suggested that government bonds from countries such as Italy and Spain should outperform this year, while Royal Bank of Scotland (RBS) said these bonds could also provide a means to hedge against higher releveraging risk, as the falling cost of capital makes borrowing more feasible.
"While U.S. firms are already engaging in M&A (mergers and acquisitions) and leveraged buyout activity, European corporates remain very conservative, mindful of the risks of lower ratings. But with positive growth in 2014, releveraging risk could gradually come to Europe, too," said RBS's head of European macro credit research, Alberto Gallo.
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Releveraging — or taking on debt — can help companies invest or generate shareholder wealth, but it increases a company's potential losses. It can also cause bond prices to fall, as businesses may opt to raise debt in the credit market, potentially increasing the supply of corporate debt.
As such, areas of the credit market with a less severe risk of rising rates and releveraging, such as financials and the periphery, were preferable, Gallo said.
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"The potential for releveraging in the U.S. and core Europe is a symptom of a stronger economy, but this presents risks to credit investors… These risks are far away in European banks and periphery corporates, which will continue to trim their balance sheets over the coming years, making their bonds a scarce asset in negative net supply" he wrote.
Europe's peripheral countries Portugal, Spain, Italy, Ireland and Greece were hardest hit by the 2008 credit crisis and subsequent European debt crisis, and are seen as riskier than their core counterparts because they are more likely to default on their government debt.
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However, a string of positive economic reports this summer have raised hopes that the region's economic recovery is becoming more entrenched. In particular, official data in August showed the euro zone grew by 0.3 percent in the second quarter from the first, although it is still expected to contract over the full-year 2013, and post anemic growth next year.
Barclays analysts Hamish Pepper and Cagdas Aksu said peripheral bonds would outperform versus Germany until year-end, due to the dovish surprise from the Federal Reserve in September, the potential for further assistance from the European Central Bank, and the return of some risk appetite.
"Core periphery spreads versus Germany have behaved very well and never underperformed much, despite the sell-offs seen in other riskier asset classes, such as emerging markets and certain segments of credits markets," they wrote. "With the 'risk-on' mode returning even to the riskier assets which were under pressure, peripheral rates should continue to perform well too."