Peripherals versus the core: the pendulum swings

European bond and credit investors have noticed an altogether different dynamic in relation to the debt of European peripheral countries (most notably that of Italy and Spain) recently. Peripheral bond spreads, a useful indicator of how much credit risk investors are expected to take relative to the ‘gold standard’ of the German bund, have enjoyed a strong rally of late, which started in October and has continued year-to-date[1].  

Historically, given the perceived safety of bunds, investors have traditionally demanded a decent degree of compensation, for the additional risk taken, as a result of having to invest in Italian and Spanish bonds.

The reasons were not hard to pinpoint – larger fiscal deficits than the core Eurozone countries, together with unstable governments, were just two. Fast forward to 2019/2020 and bunds were given a particular safety premium during the COVID-19 pandemic when supply was limited at a time of significant investor demand during this ‘risk-off’ period.

Since then, and at the time of writing, the degree of compensation demanded for investing in peripheral bonds and credit has reduced significantly. By way of example, the spread of Italian bonds debt versus German bonds, which traded as wide as 200bps in October 2023, has narrowed to 135bps today, below the average of the last decade of 165bps[2]. For historical context, these spreads widened to over 500bps during the Eurozone crisis of 2011/12.

So, what has caused this reassessment of credit risk?

La dolce vita

For much of last year, fears of potentially higher interest rates in Europe and creeping fears of unsustainable levels of debt kept peripheral bond spreads wide. That all changed following last December’s pivot from the US Federal Reserve, signalling that the next move in interest rates would likely be downwards.

In Europe, a backdrop of challenging growth, and easing inflation this year has also meant that the European Central Bank is looking to ease financial conditions going forward. For now, credit rating agencies and the European Commission have become more lenient regarding the restrictiveness of European budgets.

In short, higher real interest rates and debt-fuelled fiscal policy are no longer a headwind to carry strategies. Furthermore, on the political front, stability reigns. For Italy in particular, the government of Prime Minister Giorgia Meloni has brought much needed stability to the country.

Bund(erwhelming)

With inflation now on a downwards trend, and the risks of central bank tightening tipping the Eurozone into recession abating, the demand for bunds has reversed as the flight to quality ‘bid’ falls in the current risk-on environment.

The current disinflationary trend has also resulted in corporate issuers becoming more willing to swap fixed rate obligations for floating ones. Heavy government supply and accelerating quantitative tightening combined have meant that the free float for bunds has continued to rise, while ‘specials’ in the repurchase agreements (repos) have all but vanished.

But where could further peripheral spread tightening come from?

Going forward, the drivers for further tightening in peripheral credit spreads appear less obvious. In other words, where is the marginal buyer for peripheral bonds likely to come from? As discussed above, some of the enthusiasm has been driven by expectations of central banks cutting rates this year, which is reflected in the market interest rate outlook.  

What could bring bunds back into favour with investors again? Any upside inflation surprises, and the belief that inflation could prove stickier than first thought, could delay interest rate cuts, hence maintaining relatively tight financial conditions.  

In essence, while a near-term catalyst for peripheral spread widening is hard to pinpoint, the rise in geopolitical tensions mean investors would be unwise to abandon the safety and stability of bunds altogether, in our view. Bunds have their place in investor portfolios – they have remained a safe haven and have continued to attract flight-to-quality flows during times of market stress.

[1] Source: Bloomberg as at 22 March 2024.

[2] Source: Bloomberg as at 22 March 2024.