28th March 2014
Fixed income veteran and manager of the M&G Global Macro Bond fund Jim Leaviss, gives his thoughts on how deflation has replaced credit worthiness and default risk as the main worry for the Eurozone…
The risk of deflation has become an increasing concern in the Eurozone, and the market may have started pricing this possibility into bond valuations. For example, five-year Irish government bond yields have dropped below US Treasuries and gilts, helped by Ireland’s positive economic reforms and spending cuts. But its falling yields also partly reflect the prospect of deflation, which might have replaced credit worthiness and default risk as the main worry in the region’s periphery.
In terms of a possible policy response from the European Central Bank (ECB), a QE programme like those undertaken in the US or Japan appears unlikely. ECB President Mario Draghi confirmed at the World Economic Forum in January that the legality of this activity within EU law has been brought into question. I would therefore expect to see another interest rate cut or renewed action to stimulate lending by the ECB similar to its previous long-term refinancing operations (LTROs).
On the back of this, the M&G Global Macro Bond Fund’s sensitivity to European interest rate risk has recently been increased, mainly through increasing its exposure to German government bonds, which I felt looked better value relative to US Treasuries. With selective reductions to the latter, the fund’s overall duration has remained slightly over a year short of its neutral position, although the duration contribution from European assets is now overweight relative to a neutral stance. Euro-denominated assets currently account for 1.4 years of the fund’s duration, while most of its other interest rate risk continues to stem from US dollar- and sterling-denominated bonds, respectively contributing around 1.8 years and 0.7 years. A small remainder is derived from holdings of Swedish, Norwegian and Mexican government bonds.”