By Yoruk Bahceli
LONDON (Reuters) – Investors who earned double-digit returns from southern European government bonds are now reducing their exposure, fearful of the thinner trading volumes that dog this segment of the euro zone debt market in the holiday season.
Borrowing costs in Italy, Spain and Portugal have seen their biggest annual fall in years, down 90-135 basis points in 2019. Greek 10-year yields have plunged almost 300 bps.
Spanish and Portuguese 10-year borrowing costs even approached the 0% mark in mid-August, moving ever closer to the sub-zero yields seen in core euro zone countries including Germany, Netherlands and France.
But the rally ended in November, with 10-year yields across southern Europe climbing 15-30 bps, while German yields rose only 5 bps.
One reason is that Spanish, Portuguese and Greek markets remain far more vulnerable to year-end price swings than the bigger and more liquid “core”, and even Italy.
“We’ve liked Spain all year and we’ve done very well by being in Spain, but we actually took our profits,” said Paul Rayner, head of government bonds at Royal London Asset Management.
“If everyone exits the door on Spain at the same time, it could be messy as the liquidity is not there.”
Market liquidity – essentially the ease of buying and selling – is crucial because a selloff in thinly traded markets can mean investors struggle to find buyers for securities that are fast losing value.
So how illiquid are these markets?
On an average day in 2018, just 0.85% of outstanding Portuguese bonds changed hands. While that’s a dramatic improvement from 0.3% in 2012, it’s well below Germany’s 1.55% turnover ratio, according to the Association for Financial Markets in Europe.
In Greece, the ratio is down at a miniscule 0.04%.
Graphic – Bond turnover ratio in Portugal and Germany: https://fingfx.thomsonreuters.com/gfx/editorcharts/EUROZONE-BONDS-PERIPHERY/0H001QXN19R3/eikon.png
Graphic – Euro zone bond markets by size: https://fingfx.thomsonreuters.com/gfx/editorcharts/EUROZONE-BONDS/0H001QXMR9Q8/eikon.png
Southern Europe also scores poorly on another liquidity gauge: The gap between bids and offers, which is much wider than in core bond markets.
Greek bid-ask spreads climbed as high as 64 bps this year, while in Spain and Portugal they touched 40 bps and 48 bps respectively, Tradeweb data shows. On German Bunds, 8 bps was the peak.
Graphic – Portuguese/Spanish and Greek/Italian 10-year yield gaps: https://fingfx.thomsonreuters.com/gfx/mkt/12/9267/9179/periphery%20spreads%20nov%2028.png
“Honestly I wouldn’t dare buy some Greek government bonds,” said Cyril Regnat, head of research solutions at Natixis.
Greek spreads could gap 50 basis points wider if negative news hits, he added.
But as in any market where supply is low, increased demand would cause yields to fall more than in larger markets. Hence, investors who braved these markets in 2019 earned roughly 30% returns on Greek government bonds, according to Refinitiv data.
They would have made 10%-16% in Italy, Spain and Portugal, versus 6% in Germany.
Graphic – Southern European bond market returns: https://fingfx.thomsonreuters.com/gfx/mkt/12/9383/9295/returns0212.png
But the selling rush may not last beyond December. Spain, Portugal and Italy are among the few investment-grade rated sovereigns still paying positive yields on 10-year debt.
There is also the supply-demand equation. Natixis predicts the European Central Bank will buy 35% of euro zone sovereign bond supply in 2020, versus 20% in 2019.
That should tighten Portuguese and Spanish 10-year yield premia over Germany to 50 bps and 60 bps, respectively, over the next year from the current 75 bps or so, they said.
“(Spain) is a trade that we’ll come back to,” RLAM’s Rayner added.
(This story corrects Natixis estimate in penultimate paragraph to .. 50 bps and 60 bps, respectively ..not.. 50-55 bps.)
(Reporting by Yoruk Bahceli; Additioanl reporting by Dhara Ranasinghe; Editing by Sujata Rao and Hugh Lawson)