Relative value opportunities remain in Europe’s periphery, says BlackRock’s Krautzberger

March is crunch time for peripheral Europe, but region offers relative value trades, says co-head of European fixed income at BlackRock.

Michael Krautzberger, BlackRock

Europe’s periphery still offers opportunities for bond investors on a selective basis, according to Michael Krautzberger, co-head of European fixed income at BlackRock in London, but hopes of an imminent resolution to the Eurozone’s financial problems are overly optimistic.

On March 11, a summit of European leaders will be held to discuss German proposals to resolve the ongoing Eurozone financial troubles. That meeting is expected to prepare the ground for a further meeting, to be held on March 24 and 25, at which a far-reaching support package is expected to be announced.

Moreover, a meeting of the Economic and Financial Affairs Council (Ecofin), which comprises finance ministers from all European Union member states, will be held on March 18.

“There is a lot of hope about the March summit bringing a permanent solution to all the problems in Europe,” says Krautzberger. “But the hope that it puts all this nervousness to a final rest is aiming slightly too high. I am hoping for some progress and some mechanism to lower the interest rate burden on official loans [to ailing countries], either as an outright decision or via a rule that uses a performance incentive. I am confident we will at least see a positive decision on March 24 and 25.”

Eurozone problems have not dominated the market in the early part of 2011 as they did in 2010, when bailouts were agreed for both Greece and Ireland. Instead, political unrest in the Middle East and a rising oil price have focused investor attention.

That does not mean Europe’s funding problems are resolved but, if the rescue packages succeed, they could end up helping the core as much as the periphery, given the interest charged on bailout packages. Ireland is paying an average of 5.8% on the loans it agreed with the European Union and International Monetary Fund in November last year.

Already, there is talk of Ireland renegotiating the cost of its loans. That makes sense, according to Krautzberger, if the goal is to keep peripheral European economies solvent.

“If there really is no default then the bailouts are a hugely profitable exercise for core Europe,” says Krautzberger. “What is the biggest hurdle for a country like Greece? It has to be the fact that economic growth needs to be high enough relative to the interest rate burden, but growth is a problem when you have to save a lot and introduce fiscal austerity. There is a case for the Eurozone to lower that hurdle.”

Krautzberger sees selective opportunities in bonds in Europe’s periphery, given the current expectation that the Eurozone will do whatever is necessary to maintain solvency across its member states. Among those peripheral countries, it is the countries making most progress in addressing debt overhangs that he views as most attractive.

“There is a lot of opportunity in relative value, trading one country versus another where you see there is decent progress being made,” he says. “We have been impressed by recent policies in Spain and by the communication it has had with investors.”

Ten-year Spanish government bonds were trading at 5.5% on March 10, against 7.384% for Portuguese debt, 9.379% for Ireland and 12.658% for Greece.

Some of these countries have suffered recent downgrades by credit rating agencies. Moody’s downgraded Greece from Ba1 to B1 on March 7 and Spain from Aa1 to Aa2 on March 10.

Despite the downgrades, Krautzberger views a number of themes as creating strong differentials in value between peripheral European countries, among them yield curve steepness.

“The peripheral countries have different yield curve shapes so in Greece, where people are concerned about getting their money back, the yield curve will be inverted because nobody wants to buy a short-term instrument near 100,” he says. “But some countries have gone steeper, such as Spain, so that means there is an opportunity within Spain to move some money along the curve, even beyond the 10s to the 20s and 30s.”

Spanish 30-year government bonds were trading at 6.084% on March 10, not much higher than the 10-year yield of 5.5%. Nevertheless, the 30s were trading at just 4.85% in October, so may now offer value to investors more bullish on the country’s longer-term prospects.

Yet for other peripherals the yield curves have become inverted due to the perception of high short- to medium-term risk. Thus 30-year Portuguese government debt was trading at 6.791% on March 10, below the 10-year yield of 7.384%, while Greek 30-year sovereign debt was trading at 8.866%, almost a third less than the country’s 10-year yield of 12.658%.