With the Dutch elections behind us, there are still a series of potential catalysts for market chaos in the pipeline for 2017. We have the French elections in May, the German election set for approximately October and a series of debt tranches due for maturity in between.
While we do not want to fall into the trap of predicting the outcomes from these events, it is extremely important as contrarian investors to know your exposures. This is no more important than in European bond markets, where we must acknowledge a large range of potential scenarios over a long-term horizon, where a European Union break-up cannot be disregarded.
As risk savvy investors, awareness is key. We do not want to make an active decision between Europe and global equivalents without knowing what we would be holding and in what size.
From a European perspective, France and Italy make up approximately half of the entire European government bond universe, while Germany only makes up 18%. Therefore, if someone wants to purchase European government debt thinking it was providing exposure to AAA-rated Germany, Luxembourg or even the Netherlands, they would be misguided by buying the index. The French and Italian political situation gains added importance in this regard, and a margin of safety must be enforced to ensure an adverse outcome in either country does not materially impair our calculation of fair value.
Furthermore, the duration of European debt is also crucial, especially with the ongoing uncertainty of a European break-up over longer time horizons. While the headline ‘duration’ number shows an average of 7.5 years, we can see that only a small amount is maturing on a 10+ year horizon (13%). This creates a situation where there is a cluster of debt rolling on a 5- to 10-year timeframe (40%), far higher than most global peers. We suggest this is considered in an absolute context as well as relatively, as it will impact the sensitivity to any European volatility. To demonstrate the difference on a global scale, below we outline the same composition analysis for the entire government bond universe.
What About the Global Bond Market?
Looking with broader perspective, the global government bond universe is dominated by a large exposure to Japanese and U.S. debt. The weighting of 30% in U.S. Treasuries may be unsurprising to many investors, although many investors fail to realise that their largest exposure is actually in Japanese debt at 32%.
The maturity risk also differs slightly to European government debt, with a greater dependence on 10+ year debt. Specifically, a passive investor in a global government bond index has approximately 37% of their debt maturating beyond 10 years – versus ‘just’ 13% for the European equivalent. Therefore, while the headline ‘average’ of 7.8 years is similar to the European number, the underlying composition could play an important role as it will alter the sensitivity to yield curve changes.
The final element to be aware of is the current price of bonds and the potential for a yield spike. Knowing that further capital gains are only sustainable if bond yields continue to fall, below we depict the key European bond yields on a relative basis to Germany. We can see that both Italy and Spain have historically been significantly more volatile than France, which could have a material impact on future European bond returns as Italy and Spain comprise 25% and 14% of the index respectively.
