Peripheral bond buyers will need growth, stability

Even if eurozone leaders finally deliver a comprehensive plan to ease the region's debt crisis, investors will need stable markets and a belief economic growth is possible before lending to peripheral countries again.
That may prove a tall order as harsh austerity programmes threaten the growth needed to manage debt, while three years of market turmoil and political wrangling have undermined confidence in an asset class once seen as low-risk.
This means that even when the crisis is under control, peripheral countries' are unlikely to see their borrowing costs return to pre-crisis levels, offering a potentially attractive investment.
German Chancellor Angela Merkel and President Nicolas Sarkozy have promised a plan by month-end to tackle the crisis, including bank re-capitalisation, dealing with Greece's debt mountain and closer eurozone integration.
"Credibility and confidence has been shot and once that's gone it's very hard to get back again," said Russell Silberston, head of global interest rates at Investec Asset Management which has around $90 billion of assets under management. "The US, for example, has a shocking deficit but you have the confidence in the liquidity and that Treasuries will remain a safe-haven asset. That's what has been lost in peripheral Europe."
In recent weeks, as market anxiety has focused on Italy and Spain - two economies deemed too big to be bailed out - the European Central Bank has bought billions of euros of Italian and Spanish bonds to stop yields rising to unsustainable levels.
In the future this buyer of last resort role will be taken over by the 440-billion-euro EFSF euro zone bailout fund but, without economic growth, this alone is seen insufficient to lure investors back to peripheral bonds.
"The solution to the entire crisis is growth, unfortunately the medicine is austerity and that isn't going to work when everyone is doing it at the same time," Silberston said.
Euro zone growth has slowed sharply and Italy will expand just 0.1 percent in 2012, according to a Reuters poll. But if leaders come up with a credible plan, the higher yields offered by peripheral issuers may in time prove attractive.
"Markets aren't saying they want all the details today, but they do want a clear vision of how we're going to get there," said Sanjay Joshi, head of fixed income, London & Capital which has around $3.5 billion in assets under management.
Joshi said if things were "sorted out" L&C would sell its position in Bunds because the yield premium over Germany for countries such as Italy and Spain would be very attractive.
"But in the meantime we remain on the sidelines as there is too much political uncertainty. When that gets resolved we'll look to take advantage of the opportunities."
Investec's Silberston, meanwhile, said that before buying Irish, Italian or Spanish bonds he would need to see them behaving more as government bonds traditionally have and less like higher risk corporate bonds, as they do now. Before the first hints of the financial crisis in 2007, yield spreads of peripheral government bonds over German Bunds had been relatively steady and roughly the same for all countries since their issuers joined the euro.
Individual country risk was overlooked as investors priced a broader eurozone risk as the region became more integrated.
Not only has that country risk been factored back into government bond yields, peripheral debt has been moving in tandem with riskier assets such as equities, rising and falling sharply in line with market sentiment.
"We invest in government bonds as a store of wealth and a high quality asset. If we wanted to buy risk assets it would be on the basis of balance sheet considerations rather than just offering a high yield," Investec's Silberston said.
The yield spread between German and Italian 10-year bonds for example, is around 370 basis points, compared with 10-50 bps between 1999 and 2007 - similar to the other peripheral issuers at the time - and as much as 700 bps in the pre-euro era.
It is unlikely to fall to the low levels again as investors are now pricing a credit risk for each country.
"Until we have a defined solution to the (enlargement of the eurozone rescue fund), Italian bonds will remain under pressure," said ING rate strategist Alessandro Giansanti.
"But if there will be some guarantees from other countries, that will stop the Italian spread widening and then they can go back into the markets, although at a higher spread than before at least 200 basis points over Bunds."