Europe's ?Back-door QE?: Good News for Global Bond Investors

The European Central Bank’s (ECB) Long Term Refinancing Operation (LTRO) appears to have helped bring the European banking system back from the precipice of collapse. The ECB has helped Europe sidestep the dreaded “Lehman Brothers moment,” where a major bank failure led to a freeze in the credit markets and forced selling of everything but treasuries by investors, and there has been a palpable sigh of relief. Global bond investors now willing to look beyond the perceived safety of treasuries are likely to find that last year’s sell-off created compelling opportunities in the debt of select countries of the emerging markets and the stronger countries of peripheral Europe.

In this issue, Hemant Baijal, Vice President, Fixed Income and Robert Kinsey, Senior Client Portfolio Manager, Fixed Income explain why investors should

• Expect European Central Bank policies to continue to stave off financial crisis and potentially support markets by fortifying the European banking system
• Move beyond the perceived safety of treasuries in pursuit of sound fundamentals of debt opportunities around the world
• Seek potentially higher real yields by increasing exposure to select countries of the emerging markets

The ECB’s Long Term Refinancing Operation is an expansive liquidity provision to support the European banking system, bringing that system back from the brink of collapse. Investors have viewed this operation as a game changer for the financial markets, and so far it has been exactly so. With many market participants no longer worried about a collapse of the European financial system, they are now better able to return to a longer term focus on the true underlying fundamentals of individual securities.

For much of 2011, the valuations of higher yielding corporate bonds and emerging market debt gyrated (along with the rest of the financial markets) between risk-on and risk-off modes. If Greece and Portugal were about to default on their debt obligations and European banks were subsequently going to fail, then investors reasoned that they were better off trading their “riskier” assets for the perceived safety of U.S. Treasuries. Bonds were priced day to day, based on whether investors were applauding the incremental steps taken by European policymakers to stave off financial calamity, or condemning policy actions that would fail to support peripheral European countries or the European banking system.

Investors have been pleased by the ECB’s recent actions and placated by yet another bailout of the still-insolvent Greek government. While we also celebrate the policy accommodations, in general, our longer term views have not changed. We maintain an overweight position to the local-currency ­denominated debt of select countries in the emerging markets. We have also been selective in adding marginal positions to the stronger countries of peripheral Europe as valuations became more compelling.

Why is the LTRO seen as a game changer?

The sovereign debt crisis that spread from Portugal, Greece and Ireland to Spain and Italy, quickly morphed into a potential banking crisis through the evaporation of liquidity for European banks. Access to short-term commercial paper markets disappeared and, simultaneously, U.S. money market funds veered away from European banks—a move that exacerbated their already-reduced options for liquid­ity. The ECB’s limited involvement for much of 2011 (remember European policymakers actually raised interest rates earlier in the year) heightened investor concerns. As the markets clamored for a lender of last resort, the ECB finally obliged with its December rollout of the LTRO. Collateral eligibility standards were relaxed considerably, making it easier for banks to obtain much-needed funding. Anecdotal evidence suggests that many banks, previously unable to gain access to liquidity, bridged their first-quarter funding needs by accessing the ECB’s liquidity provision. Importantly, European interbank lending rates trended lower. (See Chart 2.)

In the eyes of capital markets, the LTRO worked by significantly diminishing the risk of a liquidity-driven bank collapse on the Continent. The ECB is now set to embark on further expansion of the LTRO. Estimates as to the take-up by banks in this second round vary wildly (€250 billion to €1 trillion). The allowable collateral has been expanded to include a variety of assets on bank balance sheets, including performing loans that could relieve much funding stress. The prospect that banks will utilize the LTRO to engage in more sovereign carry trades—and either buttress or dampen the yields on Spanish and Italian sovereign debt—seems high in our view. Some may call this a “back-door QE” on the part of the ECB; nevertheless, the impact should continue to be palliative. While this is a bridging strategy and not a total solution, it contrasts with the seeming inac­tion, or lack of a “big bazooka,” of past initiatives.

The ECB’s expansive liquidity provision alone does not solve Europe’s problems. The Continent will continue to contend with the prospects of a pro­longed recession. The restructuring of Greek debt cannot, by itself, solve that country’s debt woes. Furthermore, the potential stands for Portugal to be next in line to restructure its debt. The so-called “bond vigilantes” remain, well, vigilant, since borrowing costs in Greece continue to rise and, in Portugal, remain elevated.

Still, overall, the expanded liquidity has apparently greatly diminished the likelihood of the much-feared “Lehman Brothers moment,” which certainly changes the game in Europe and for bond investors around the world, who can now divert their atten­tion from Europe’s woes and refocus on solid bond issuers around the world.

Refocus on value now possible

No doubt, we consider ourselves bond vigilantes. Public Debt and Fiscal Balance as a Percentage of GDP (2010) Our exposure to peripheral European debt was minimal heading into the crisis, and it remains so. In our view, the reduction in the probability of truly horrible outcomes, such as a series of bank collapses or a core European sovereign losing access to the bond markets, justifies the rally in “risky” fixed income assets. We are value investors, and as such, we don’t believe there are bad bonds—just bonds with bad prices. The current pricing of Greek or Portuguese bonds, for example, is still not enough to bring us into those markets. We have, however, found value in Italian bonds and added exposure, particularly around the time rates spiked last fall. We maintain that Italy is a solvent country and believe that the size of its budget surplus in 2013 (if not sooner) will be a positive surprise to the markets. We hold similar views on Spain (a country with a debt level to total output ratio that is actually less than the U.S.). Additionally, the relative value of what we think are sound corporate bonds in Europe is still compelling. Some issuers have been unduly tarnished by the problems of their home country’s sovereign debt.

EM local debt still looks good

Little has changed in our minds during the past year as to the capacity of select emerging market governments or companies to service their debts. Throughout the Eurozone crisis, we have main­tained our exposure to emerging market local debt and have increased our allocation to emerg­ing market corporate bonds. We maintain our favorable opinion on the important strides that emerging market policymakers have taken dur­ing the past couple of decades. It is important to note that even with the recent bailout of Greece, a disorderly default by Greece is still probable. In that case, risk assets (including emerging market bonds) may fall under pressure. We would likely view any pullback in emerging market debt values as a buying opportunity.

The juxtaposition of the current plight of many of the world’s developed economies and the current state of the emerging markets illustrates our view very well: Debt levels of emerging market countries remain well below those of the developed world. (See Chart 3.) Emerging market monetary policymak­ers also boast policy flexibility that is the envy of the world’s developed market central banks, which are facing the limitations of zero yields. Policymakers in many emerging markets tightened policy last year to stave off inflation and many continue to run counter­cyclical policies in 2012, easing conditions to support growth. Real yields in many countries across Latin America and Asia remain attractive as policymakers work to mold an appropriate mix between growth and price stability. We continue to favor the local-currency­ denominated bonds of countries such as Brazil, Mexico, South Africa and Indonesia, all of which we believe have strong growth prospects, reasonable debt levels, sound inflation-fighting credentials, and cur­rently offer attractive real yields. We also added “higher beta” countries and currencies (forint-denominated Hungarian bonds, for example) on the margin early in January in response to the ECB’s actions.

Risks remain

Investors willing to look beyond the headlines and focus on true fundamentals may recognize attrac­tive long-term investment opportunities. Through all the uncertainty and the recent favorable steps taken by the ECB, we have continued to favor the debt of select countries and companies of the emerg­ing markets. As value investors, we will continue to search the global debt markets for the most attrac­tive investment opportunities.

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