Rate hikes pose bigger threat than ever to European debt

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European bond investors are heading into this rate hike cycle more vulnerable than they have ever been before, suggesting that the painful sell-off of recent weeks may be just the beginning.

Bonds have fallen this month as the highest inflation in decades prompts traders and banking analysts to outdo themselves by betting on more hikes from the Federal Reserve and Central Bank European. The latter should now reduce its key rate to 0% this year.

Even as ECB chief Christine Lagarde has tried to push back expectations for the euro zone, the sharp moves in long-term debt from Germany to companies like Deutsche Bahn AG and Nestlé SA are calling into question the status as a “safe haven” for these securities.

The driving force behind this is a metric known as duration – a measure of how sensitive bonds are to rate hikes. That jumped after years of cheap borrowing costs and ample liquidity led to borrowers taking advantage by extending their maturities.

For European government bonds, it is now 8.27 years, more than two years earlier than the last time the European Central Bank raised rates in July 2011, according to data from the Bloomberg index. The corresponding figure for blue chip corporate debt in euros is one year higher at 5.13 years.

“So far, it’s the front-end that has suffered the most from the recent sell-off,” said John Taylor, portfolio manager at AllianceBernstein, which manages $5.4 billion in funds. “As attention shifts to the impact of quantitative tightening, the market price will begin to embed more of a term premium for longer-term debt in the 10s and 30s.”

Taylor funds increase cash and other floating rate instruments that are shielded from interest rate and credit market volatility. A key indicator of expected price moves for the bond market – one-year options on two-year volatility – hit its highest level since 2011 this week. “There is no refuge at the moment. So staying out of the market for a month or two is not the worst thing,” he said.

Reflecting Taylor’s sentiment, the glut of liquidity in the euro zone economy hit a record high above 4.5 trillion euros ($5.1 billion) this month.

Amundi SA, Europe’s largest fund manager, also issued a warning. In a recent note, the company advised investors to maintain a short duration bias as traditional bond benchmarks face the challenges of low yields and high duration risk.

While rates and investment-grade debt markets are usually the first in sight during an up cycle, the increased duration means this period could be particularly brutal.

“All the assets that benefited from the extraordinary stimulus now have a higher duration and are vulnerable,” said Pierre Verle, high-yield debt portfolio manager at Carmignac Gestion SA, with $1.5 billion in assets. under his responsibility.

Within credit, floating rate notes and junk debt can offer a way to reduce duration risk. Patrick Armstrong, chief investment officer at Plurimi Wealth LLP, prefers high-yield bonds to German bonds or US Treasuries, he said in a recent Bloomberg TV interview, especially since the risk of default remains weak. A Bloomberg index listing high-yield euro notes had a duration of 3.8 years as of February 11.

Some investors look even further. According to Verle de Carmignac, clients invest in private equity, venture capital and real estate to reduce their exposure to interest rates – although these asset classes are also sensitive to rate hikes, even if the The immediate impact is not obvious, he said.

For Philipp Burckhardt, fixed income manager and strategist at Lombard Odier Investment Managers, the best approach is to take on a combination of duration and credit risk. The company sees fallen angel bonds, which are those downgraded to investment grade, as a sweet spot.

“At the end of the day, everyone needs performance – and to get there, you need a combination,” he said.

Next week

Investors will be watching another big weekly list of ECB speakers for more clues next week, including Lagarde and chief economist Philip Lane.

  • Eurozone and German economic numbers are light on the ground, with February ZEW being the only number of note. The UK agenda is busier and headlined by January inflation and retail sales.

  • Eurozone bond sales from Germany, the Netherlands, France and Spain are expected to total 33 billion euros ($37.6 billion). The United Kingdom sells 2.25 billion pounds of 10-year bonds.

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Mary I. Bruner