With Europe Facing Deflation Risk, Long Bonds Offer Shelter

An employee of Austrian central bank (Nationalbank) shows a restored 500 euro banknote at their bank's headquarters in Vienna. (Reuters Photo/Leonhard Foeger)

By : John Geddie | on 11:00 PM May 07, 2016
Category : International, World

London. A surge in sales of long-dated bonds in the euro zone this year shows how worried some money managers are that the bloc is sinking towards a Japan-style decade of deflation.

As euro area governments seek to lock in historically low borrowing costs, the share of bonds sold in 2016 with maturities of 12 years and above is the highest it has been since the bloc was formed. Eyecatching 50-year and 100-year issues have been in demand.

The natural home for this debt is pension funds and insurance companies seeking to match their long-term liabilities and lock in positive returns in a world where $10 trillion of sovereign debt now trades with yields below zero.

But these investors, who tend to hold bonds to maturity and harvest the annual interest payments, have been joined by a group of asset managers looking for outsized capital gains in case the European Central Bank fails to lift inflation and yields fall further.

"It helps me sleep well at night," said Brian Tomlinson, a senior portfolio manager at Allianz Global Investors, who recently bought 50-year bonds from France and Belgium.

"It protects the portfolio if Europe enters a prolonged deflationary environment like Japan has experienced."

Two hundred investors placed 8 billion euros of orders for a 50-year bond from Belgium last week, while nearly 7 billion euros was pledged for France's 50-year bond earlier in April. With each country issuing only 3 billion euros of the bonds, many potential investors would have been left disappointed.

This high demand is even more remarkable given the modest returns on offer. The fixed interest, or coupon, on France's bonds was 1.75 percent, shy of the ECB's near 2 percent target inflation rate, meaning investors in this bond could lose money in real terms over its life.

But the low coupon on these bonds can be a bonus for the investors looking to hedge the possibility of a dive lower in yields.

The lower coupon increases the "duration" of the bond, or its sensitivity to changes in underlying rates, meaning it will outperform in a portfolio if there is an economic shock or deflationary spiral that pushes yields sharply lower.

Consumer prices in the euro zone fell by an annualized 0.2 percent in April, and inflation has been hovering near zero for the best part of two years even though the ECB has injected trillions into the economy via monetary easing.

"As long as we stay in this muddle-through scenario the coupon on a 50-year bond is very valuable and you have a protection against tail risks," said Gerard Moerman, head of rates and money markets at Aegon Asset Management.

Moerman also recently bought 50-year bonds from France and Belgium, and said he would be "interested in opportunities" to invest in 100-year debt.


For the same reason, Allianz's Tomlinson says he is also buying Britain's ultra-long bonds to insure against the prospect of the UK voting to leave the European Union in a referendum next month, which some say would weigh on its economy.

A major 'tail risk' for the euro zone is that it follows Japan into a lost decade of falling consumer prices and low growth. Long-term inflation gauges for the euro zone, which have tended to move in line with the U.S. counterparts, have recently diverged for the first time in two years.

Yet holding ultra-long bonds as insurance is a high-risk strategy. For the same reason bonds with a higher duration outperform if rates fall, they can also be a burden if inflation trumps expectations and rates start to rise.

Ben May, lead euro zone economist at Oxford Economics, argues the bloc is on the cusp of exiting this period of low inflation. He believes consumer prices will pick up sharply later this year which will be enough for the ECB to justify no further monetary easing.

"If you want protect against a very negative outcome then long duration would be the way to go, but for us the risk/reward seems like it would be tilted unfavorably," said Chris Chapman, fixed income portfolio manager from Manulife Asset Management.


Show More