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Roman roulette

7 February 2012 By Neil Unmack

Europe’s bond investors may have already missed the best trade of 2012. While many fund managers were steering clear, Italian government debt rallied in January, outperforming other euro zone sovereigns. But those who missed the boat may find better value elsewhere.

At the end of last year, many investors – and Breakingviews – were sceptical that the European Central Bank’s three-year bank liquidity would spark a rally in peripheral government debt. They were wrong. Yields on Italian 10-year bonds fell from about 7 percent to 5.9 percent in January, giving brave investors an 8 percent return, before including any coupons.

As Italy accounts for nearly a quarter of the Barclays Capital Euro Treasury Bond index, investors who were underweight Rome have fared poorly. Of the 302 funds tracked by Morningstar that invest in euro-denominated government debt, just 58 beat the index in January. The winners include some savvy funds, as well as the European Central Bank, which has bought perhaps 100 billion euros of Italian debt since August last year.

The losers can console themselves with the thought that the rally has further to run. If Italian 10-year yields fall to 4.8 percent – roughly where they were before the country was dragged into the euro zone crisis last summer – there’s another 5 percentage points of upside from today’s prices.

But there are risks. The rally has been fuelled by expectations that euro zone banks will borrow as much as one trillion euros from the ECB at its next auction at the end of February. But stronger lenders such as Deutsche Bank say they will not take ECB money, increasing the stigma for those who do. A low take-up could unsettle markets. Meanwhile, Italians could tire of austerity, or the country’s economic performance could disappoint.

There could be better opportunities elsewhere. For example, investors prepared to bet that Ireland will not renege on its bank guarantees can buy Allied Irish Banks’ government-guaranteed bonds with a four-year maturity at a yield of nearly 11 percent. That compares to a yield on five-year Irish government debt of just 5.8 percent. If the worst is truly over in the euro zone, there are still rich pickings to be found.


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