(Bloomberg) — Diving into the riskiest parts of Europes government bond market proved to be a clear winner this year.
Some of the worlds biggest money managers say 2016 will be no different.
BlackRock Inc., Pacific Investment Management Co. and Prudential Financial Inc. all say debt from Europes peripheral nations — those less-creditworthy borrowers such as Portugal, Italy and Greece — are primed to excel once again as the European Central Bank extends its unprecedented bond buying. With the Federal Reserve finally raising U.S. interest rates, theyre taking a dimmer view of Treasuries as forecasts suggest the securities are headed for losses.
While Europe was roiled by concern a Greek default would splinter the currency union, international investors are nevertheless wading deeper into the riskiest euro nations — a vote of confidence that suggests its members can avoid a repeat of crises over the years that almost tore the region apart. Tepid growth and the risk of deflation also mean ECB President Mario Draghi may need to step up stimulus in 2016 — which JPMorgan Chase & Co. says will help Europe outperform the U.S. as monetary policies diverge.
A lot of these credits that were feared to be disasters like the peripherals from Spain all the way down to Greece, had events for years and theres going to be political and economic challenges going forward but those have been the best performers, said Robert Tipp, the chief investment strategist at thefixed-income unit of Prudential, which oversees $947 billion globally.
Overweight Stance
Tipp said the firms global funds are maintaining their overweight stance on bonds of peripheral countries in 2016, which means they hold a greater proportion of the securities than their allocation in benchmark indexes.
Those nations have led the charge this year. Greek bonds returned 22 percent as the Mediterranean country recovered from a debt showdown with creditors led by Germany and implemented measures to curb government spending. Debt issued by Italy and Portugal also returned more than 3 percent. Higher-rated countries, such as Germany and the U.S., have lagged behind.
Although the greenbacks appreciation this year would have eroded those returns for dollar-based money managers, Tipp says most big global investors hedge away that risk when they invest outside their home country. In fact, quirks in forwards market pricing have meant dollar-based investors have added to their returns when hedging, Tipp said.
Going into 2016, Portugal is a favorite for Scott Thiel, BlackRocks deputy chief investment officer for fundamental fixed income.
A big reason is the potential return on Portugals debt. At 3.70 percent, the countrys 30-year bonds yield almost 2.4 percentage points more than comparable German bunds, the regions benchmark.
Quantitative Easing
Gains are likely to increase as the nations economy improves and the ECBs debt purchases — which currently stand at 60 billion euros ($65 billion) a month — drive prices up and reduce the yield gap between the two markets.
Even after Portugals ruling coalition lost power to the minority Socialist government last month, the nations borrowing costs have fallen faster than those of Germany.
Its an obvious investment, said Thiel, whose New York- based firm oversees $4.5 trillion as the worlds largest money manager.
BlackRock is the biggest owner of Portugals bonds due in February 2045, holding more than 10 percent of the securities, data compiled by Bloomberg show. They have returned in excess of 10 percent since they were issued at the start of the year.
Investors were reminded of some of the risks of holding lower-rated debt. Spanish bonds sold off after an inconclusive election on Sunday put the nation in uncharted political territory that could require long negotiations before a government is formed. While Spains 10-year yields climbed the most in two weeks, the reaction was muted across the rest of the euro area.
Pimco, which oversees $1.47 trillion globally, is also bullish on peripheral bonds such as those issued by Greece. Despite the relative lack of liquidity for the securities, the firm is the largest holder when it comes to investment advisers, regulatory filings compiled by Bloomberg show.
Greek Drama
Among the firms biggest investments in Greek debt are notes due in April 2019, held by the $52 billion Pimco Income Fund, the data show.
Since slumping below 40 cents in July, when Greece was at the brink of financial ruin, the notes have soared and now trade at about 92 cents. And whileaverage borrowing costs are hardly low by standards of developed nations, those for Greece have tumbled from a peak of 22 percent this year to8 percent today, data compiled by Bloomberg show.
Theyve gotten the Greece drama behind them, Draghi is running the appropriate and effective policy and so there are opportunities in the European periphery bonds, said Richard Clarida, the global strategic adviser at Pimco.
That contrasts with the firms underweight on Treasuries. Particularly for shorter-dated debt, the bearishness reflects the prevailing view that Draghi will have to step up the ECBs stimulus to combat weakening growth and inflation, at a time a stronger U.S. economy pushes Fed Chair Janet Yellen to tighten policy, said Gianluca Salford, JPMorgans European rates strategist.
Very Clear
The message is very, very clear, he said.
According to the median forecast in a Bloomberg survey, yields on 10-year Treasuries will rise to 2.75 percent by the end of 2016 from 2.22 percent as of 8:58 a.m. Monday in London. If that happens, investors will lose about 1.9 percent.
Since the late 1970s, U.S. government bonds have posted annual losses just four times — in 1994, 1999, 2009 and 2013, data compiled by Bank of America Corp. show.
Still, Treasuries have been a far better investment than most euro-denominated bonds for investors who chose not to hedge their currency risk.
For Japanese yen-based bond buyers, Treasuries have returned 2.6 percent this year, while losing 7.2 percent on euro-sovereign debt, data compiled by Bloomberg show. Japanese investors have been buying U.S. bonds and paring euro-area debt, with the biggest sales coming at the expense of German bunds.
New Normal
Even Pimcos Clarida says that regardless of where you invest, returns will be meager.
We are in a low-return world, theres no doubt about it, he said.
Thats promptedBlueBay Asset Managements Mark Dowding to look further afield. Hes a fan of Cyprus, which has improved since the emergency rescue package in 2013. Moodys Investors Service raised its rating for the countrys debt last month, citing a faster-than-expected economic recovery and Cypruss ability to meet its fiscal targets.
Since they were soldin October, Cypruss euro-denominated 10-year bonds have rallied, pushing downyields from 4.25 percent to 3.88 percent.
In Europe, we continue to believe that in the periphery, spreads can continue to grind tighter, saidDowding, who helps oversee$60 billion at BlueBay.
BlackRocks Thiel says the biggest opportunities lie beyond the highly-rated debt markets of the U.S., Germany and the U.K., which provide little in return beyond the low yields that they carry.
If I look forward into 2016, I dont see a reason to own gilts, I dont see a reason to own Treasuries, and I dont see a real reason to own bunds, he said. In Europe, peripheral markets are still very attractive.
