Why Europe's sovereign bonds are on fire right now

Europe’s governments rushed to borrow money this week, drawing record demand from global investors keen to secure bonds with solid yields while they still can.

Central banks and funds from the Middle East and Asia were only too happy to lend to the likes of Spain, Italy and Belgium, all of which reported historic order books. Global money is grabbing the yields on offer before expected interest-rate reductions later this year, with a bond rally across the region on Friday as markets added to bets on cuts.

It’s an encouraging sign for European nations, which are making an early start on funding 2024’s budgets at a time when the region’s central bank has turned from propping up the bond market as a major buyer to shrinking its holdings. For investors, Europe is finally offering a window of decent returns after years of sub-zero rates kept many away.

“International buyers, especially Japan and Chinese investors, are buying much less of US Treasuries than they used to and are diversifying their holdings more to Europe,” said Raphael Thuin, head of capital market strategies at Tikehau Capital, which manages €42 billion. That includes both central banks and pension funds, he said.

Borrowing from governments via banks topped €41 billion ($45 billion) this week, an all-time high, and drove record overall European bond sales at more than €120 billion this week, according to data compiled by Bloomberg. While January typically sees strong demand, analysis of order books points to deeper appetite from Asia and the Middle East.

Take Belgium, for instance. Orders for its 10-year debt were more than 10 times the €7 billion on offer, and nearly one-fifth went to regions outside Europe, compared to about a tenth in a similar sale two years ago.

For the debt of higher-rated sovereign nations in the euro area, the share of foreign investors had fallen to around a quarter at the end of 2022, down from nearly a half in 2014, according to figures from the European Central Bank. That shows the potential influx of cash returning from investors outside Europe is massive.

Analysis by Bank of America Corp. strategists implies as much as €7 trillion could flow into euro-area fixed-income assets in coming years. They pointed to ECB deposit rates at a record 4%, surpassing levels seen before the euro-area debt crisis sent rates below 0%.

“This supports our call that 2024 supply, even if higher than 2023, can be well absorbed,” Bank of America strategists Erjon Satko and Sphia Salim wrote in a note. The level of demand for this week’s deals “suggests particularly healthy demand.”

STABLE EURO

Inflows to Europe’s fixed-income market may be removing a fundamental drag on the region’s single currency, which has rebounded from below parity with the dollar in late 2022 to around $1.0960 currently. Analysts in a Bloomberg survey see the euro rising further to $1.12 by the end of the year.

“The euro is clearly seen as stable once again. From Asian and Middle East investors in particular, there isn’t this redenomination risk being priced in in the same way as there was between 2010 and, say, 2016 or 2017,” said Frederik Ducrozet, head of macro research at Pictet Wealth Management. “It’s no longer a topic of discussion. You can’t discount the possibility of future crises, but even the populists in Italy, France and elsewhere are playing by the European rules. So this is a positive for attracting investment into the sovereign bonds.”

That could also help keep investors onboard. In the past, “fast money” — market parlance for hedge funds — has inflated order books, only for these traders to flip the bonds swiftly to make a quick profit. That doesn’t seem to be happening now, said Kaspar Hense, a senior portfolio manager at RBC BlueBay Asset Management.

“Bonds continue to tighten after the deals on the second and third day, which is a very good sign for an improving demand picture,” he said. “Most investors had lightened up to some extent and are now struggling to get enough exposure.”

Banks are also boosting the demand, given government bonds are now looking cheaper versus European rate swaps, used as a benchmark to compare debt returns.

“Bank treasuries are such a big part of the asset class, and with the move in the swaps market we are seeing cash being deployed,” said Neal Ganatra, head of SSA Syndicate EMEA at Deutsche Bank AG.

SLOWDOWN HEDGE

Not everyone has piled in. While Candriam’s global head of multi asset Nadege Dufosse is sitting on the sidelines, preferring to wait for yields that are a little higher, she still prefers bonds over equities.

“One reason why we are more keen on bonds than equities is because the highest risk today is to be disappointed by economic growth,” with a soft economic landing now the consensus view, she said. If growth disappoints, “the bonds part of your portfolio will hedge the equities side.”

ECB President Christine Lagarde said Thursday that Europe isn’t in a serious recession and that the worst of the fight against inflation is over, helping drive the bond rally Friday. While the region’s governments will need to repay all this borrowing down the road, Italy — a bellwether for debt investor nerves — is looking less risky these days. Its debt load is about 140% of gross domestic product — high, but down from 158% three years ago.

So the bonanza of government sales — with the likes of the European Union and UK yet to come this month — will likely continue for a while. Still, the pace and corresponding demand won’t last indefinitely. Yields are expected to be less appealing for investors since money markets see the ECB slashing interest rates by 140 basis points this year.

“The scale of the turnaround from “higher for longer”, or even “higher forever,” in October last year to now expectations of rapid rate cuts has created this ideal market,” said Lee Cumbes, head of debt capital markets EMEA at Barclays Plc. The “deals are a big green flag for other sovereigns — markets have been reminded of how interesting fixed income can be.”