Bond fund managers brave ‘the ring of fire’

Government bonds are traditionally viewed as one of the less racy asset classes in the investment palette, but they have been grabbing their fair share of the headlines of late.

Worries over the ability of Greece, Portugal and other heavily indebted eurozone states to honour their obligations have seen yield spreads over German Bunds hit record levels.

The mountain of debt issuance due from the US and UK has also provoked worries, with Bill Gross, managing director of Pimco, warning that the UK is a “must avoid”. “Its gilts are resting on a bed of nitroglycerine,” he added, as he placed the UK in a “ring of fire” alongside the US, Ireland, Spain, France, Greece, Italy and Japan.

But bond fund managers, while not blind to the dangers, appear to be more sanguine.

“Some of the sweeping statements that we have seen in the press, on reflection, might seem to some people to be self serving,” says Robin Creswell, managing principal of Payden & Rygel Global.

Jim Leaviss, head of retail fixed interest at M&G, adds: “We are running levels of debt that at the moment don’t look too horrendous. The UK and US don’t have much to worry about,” he says, furnishing figures that indicate sovereign defaults have fallen to well below their historic average in recent years.

Managers are relaxed about Greece in the almost universal belief that, should the worst happen, the country will be bailed out.

“The problem is not whether to help Greece but how to help Greece. Letting the country go would be a nuclear option,” says Nicola Marinelli, fund manager at Glendevon King, whose portfolios hold up to 10 per cent of Greek debt. *Mr Marinelli believes a Greek default, and the attendant stress on the eurozone, would be “unpalatable” to the European Commission. Further, he argues such an eventuality would be “catastrophic” for French banks.

He estimates that the French banking sector’s exposure to Greece is equal to 3 per cent of French gross domestic product, while the figure for Germany is 2 per cent and for Switzerland 10-12 per cent.

Mr Leaviss paints a similar picture: “There is not a great deal of political will from Germany to step in and support Greece now, but when it comes to one minute to midnight, in April/May time when some debts [€16bn (£14bn, $22bn)] start coming due, almost certainly Germany and France will blink because their banks are quite exposed,” he argues.

Mr Leaviss believes the International Monetary Fund would be involved to broaden the base of rescuers, while Athens itself may have a stronger hand than some believe.

“If you join a club that has never had anyone leaving it before you are in a great position. They don’t want to see countries leave the eurozone at the first sign of stress. If Greece goes you start to look at who is next.”

Mr Marinelli has been buying five-year Greek debt in the belief that “there is a price for everything” and that spreads over Bunds, at 350 basis points, have already reached attractive levels. Schroders is another house that has increased its exposure to Hellenic sovereign debt during the past two months.

Although confident of a bail-out, if necessary, Schroders believes the key question is how much of the cost of a restructuring will be borne by creditors. Given current pricing levels, it calculates a default that wiped out 23 per cent of contractual payments would still deliver a return from 10-year Greek bonds equivalent to that available from German Bunds.

Mr Creswell likens buying Greek debt to the purchase of bank debt a year ago, when expectations of government support proved accurate, fuelling strong returns.

He reports that hedge funds are now taking levered bets on Greek debt, lubricated by cheap borrowing, while figures from Data Explorers suggest there has been no pick up in shorting of Greek bonds, with 10 per cent of issuance on loan, the same as a year ago (compared to 59 per cent of Romanian sovereign debt).

A Greek rescue would also lend support to the debt of other weak eurozone nations, although some, such as Mr Marinelli, are still steering clear of Portuguese bonds in the belief that spreads over Bunds will widen further.

Fund managers are also relatively relaxed about UK gilts. Indeed, M&G is so relaxed a number of its funds have sought to augment their returns by writing credit default swaps, effectively offering insurance against a UK default, earning 85 basis points of the sum insured.

Some fear the sheer volume of impending issuance will push gilt prices lower, and yields higher, particularly as the Bank of England, which has bought more than a fifth of the entire stock of gilts, has suspended its £200bn quantitative easing programme.

But Mr Creswell argues: “It is not axiomatic that because there is a lot of government issuance in the pipeline that government bond yields have to go through the roof.”

Indeed, analysis of US 10-year sovereign yields since 1985 show a correlation of -0.7 per cent with federal debt as a percentage of GDP – yields are low when debt levels are high, and vice versa.

Mr Marinelli does fear a modest credit rating downgrade for the UK if the upcoming general election delivers a hung parliament, but his solution is to concentrate in short duration debt, rather than leave the market entirely, a strategy also favoured by Invesco Perpetual.

As to the bed of nitroglycerine that Mr Gross believes underlies UK gilts, M&G has the perfect riposte, pointing out that the substance is “one of the oldest and most useful drugs for restoring patients with heart disease back to good health”.

Copyright The Financial Times Limited 2017. All rights reserved. You may share using our article tools. Please don't cut articles from and redistribute by email or post to the web.