01 July 2019

A Whole New World

By Matthew D. Jackson

This weekend I was dragged to watch the new “Aladdin” at the cinema. Much like Ali and Jasmine, European credit investors seem increasingly comfortable throwing themselves off the balcony, safe in the knowledge that the ECB’s magic carpet will spare them from harm.

With 10-year German bund yields at -0.3%, custodians charging around -0.6% on uninvested cash and the ECB eyeing further stimulus, the reach for yield is in full swing. To understand why, the French “Livret A” savings product provides a useful anecdote. French retail investors may currently contribute a lifetime total of €22,950 into this tax-free savings account, which promises to pay 0.75% per annum. The proportion of the EUR investment-grade credit markets offering a yield in excess of 0.75% has shrunk from around 65% at year end to just 30% today. As the selection of bonds offering an acceptable yield diminishes, a Livret A fund has no choice but to go down in quality and/or longer in maturity in its investments to meet the required yield. A recent estimate of the aggregate size of these funds is €280 billion.

This need for yield has not been lost on bond issuers. Last week we saw a relatively rare phenomenon—twice—with the issuance of 30-year EUR-denominated bonds from A rated issuers Medtronic and Unibail-Rodamco. Only a handful of such long-dated EUR issues have printed in the past decade, although we suspect these won’t be the last.

30-year maturity bonds are nothing new or remarkable in the Sterling or US markets where there have long been consistent structural demand for long-duration assets from pension funds and insurance companies to match long-dated liabilities, but we question how much structural demand there really is for long-duration EUR paper.

At current coupons, this week’s 30-year issues have durations of around 23 years, offering a yield of just 1.8%. A 50-bp increase in the yield of these bonds would therefore leave investors nursing a -11% return. As Gordon Brown argued in his recent blog post, German Bunds: Can Yields Fall Further?, we believe German bunds are materially overvalued and as a result we do not rule out such an outcome. Substantial price volatility and higher yields would likely spook today’s “forced buyers” and see capital return to higher quality and/or shorter duration assets.

We face the same dilemma as every other European investor given today’s yield-starved environment. However, we believe investors should be very careful of accumulating too much long-duration EUR credit—the currently supportive technical backdrop could turn quickly. Instead, we believe the best risk/reward for yield-starved investors continues to be found in shorter duration bank capital securities.