A silver lining for risk

Investors had a great deal to worry about in 2011. The Eurozone funding crisis escalated. The global economy lost considerable momentum and fears of a double-dip recession spread. Banks stocks fell and financial institutions were able to tap capital markets only sporadically. All of this raised ominous memories of 2008. It was little wonder then that investors reacted to the uncertainty by selling anything remotely risky and flocked to the perceived safety of German Bunds and US Treasuries.

Credit premium for bunds to increase

However rational it might seem for investors to search for pockets of safety during uncertain times, we believe this zero-diversification strategy of shifting into Bunds and equivalents might not be such a good idea going into 2012 and over the medium term. The German sovereign five-year credit default swap (CDS) hit 120 basis points (bps) at its peak in early October, clearly reflecting the increased likelihood of further fiscal integration within the Eurozone. Germany already guarantees nearly one third of the European Financial Stability Facility (EFSF), and we think the general burden may rise. Even if the idea to leverage the EFSF through a special purpose vehicle or via a banking license may go nowhere, other attempts are afoot to contain systemic risks whether through capital injections into banks, turning the EFSF into a bond insurer as proposed by the latest summit or extending the European Central Bank`s Securities Markets Programme. We believe the latter option is likely to be the smoothest way to hold the Eurozone together, without requiring the time-consuming and complicated approval of European parliaments. The bottom line for the Eurozone in 2012 and beyond, however, is that the German taxpayers will likely be the ones shouldering the largest tax burden, thus precipitating a higher credit premium and headwinds for Bund yields.

ECB follows Fed's lead on reflation

Moreover, central banks in advanced economies have embarked on a route towards reflating their economies by flooding the markets with unprecedented amounts of liquidity. The ECB is following in the path of the US Federal Reserve by injecting further long-term money, cutting rates and launching a second covered bond buying programme. Add to that near-term inflation stickiness driven mainly by resilient commodity prices and we believe this policy may sow the seeds for higher inflation rates in the medium term ? not ideal conditions for extremely low core rates.

Economic backdrop more resilient than expected

August saw leading indicators plummet, raising fears of a return to 2008. However, economic indicators since then have pointed to a broad pause in economic growth rather than to an outright recession. While fiscal consolidation will continue to be a drag on economic activity in 2012, we believe a double-dip scenario is not as likely as many pundits suggested. Against the backdrop of the unprecedented sharp yield declines in the Eurozone's core bond markets and high levels of volatility in the summer of 2011, we believe a repricing of recession probabilities may send Eurozone bond yields markedly higher in 2012 without altering the general low yield environment.

The hunt for yield

In our opinion, risk-averse investors in Europe are caught between a rock and a hard place. While anxiously avoiding European peripheral bonds and reducing exposure to credit, the risk in their portfolios has ? contrary to their intention ? increased, with pure interest rate risk replacing diversified credit risk. In addition to this, record-low yields in core markets are nowhere near sufficient to ensure reaching nominal return targets envisaged by many investors in Germany. In order to close that gap, we believe investors will have to reverse course and creep back into more risk-prone asset classes and segments. And indeed, the recent market rout has created value opportunities, as we think that the risk-selling has been indiscriminate.

Euro credit offers attractive valuations

Euro high yield bonds spreads nearly tripled from their lows in May, soaring to a cyclical high in early October.¹ Given a recovery rate of 40%, the spread level suggests an implicit default rate of roughly 9% compared to a bit more than 2% currently expected in one year's time by Moody's.² A 9% to 11% default rate is generally assumed to be the average yardstick for a normal recession. Although default rates were much higher in the immediate post-Lehman Brothers period, high yield bond prices are now historically low and would represent a significant value opportunity, should a recession in the Eurozone be averted or turn out to be very shallow.

The same holds true for euro-denominated investment grade bonds. The spreads of bank seniors (senior unsecured bank bonds) and peripheral companies have exploded, leading to the overall index spread exceeding what was observed during the 2001-2003 recession.³ Senior bank spreads are even well above the levels seen in the post-Lehman Brothers period, owing to lingering fears of bank defaults. With some progress in view on the Eurozone funding crisis and the underfunding issues of some European banks, we believe good senior financials may offer attractive value in the medium term.

Crisis of confidence, not fundamentals

Even peripheral sovereign bonds may offer value. As evidenced by the persistent spread tightening of Irish government paper since July,⁴ we believe the market may not be completely blind to progress in fiscal consolidation. Moreover, in our view, the combination of slow fiscal healing in some peripheral countries and increased awareness by policy makers to find meaningful solutions to the Eurozone debt problems may turn around the anxious sentiment of hyper-nervous investors. Based on that, we believe Spanish and Italian bonds might offer an attractive carry and diversification opportunity as well as a chance to address potential yield convergence, should the market regain confidence.

Bumpy road ahead

Having said that, we think volatility is most certainly here to stay during 2012, as the road to fiscal integration within the Eurozone may continue to be very bumpy and clarity about the economic development is low. Hence, risk premiums are likely to stay at high levels for longer, as the market prices tail risks for a systemic meltdown and a higher probability of recession. In our view, any moderate outcome of Europe's debt problems in 2012 makes the current valuations of European credit, peripheral sovereign and many covered bonds looking incredibly underpriced. Therefore, we believe a strategy that also takes account of opportunities and selectively increases exposure to good credits and peripherals by buying into weakness should be able to offer excess returns over a pure core market-centric portfolio in 2012.

1. Bloomberg as of October 21, 2011
2. Moody's Default Report, October 2011
3. Bloomberg database
4. Bloomberg as at 21October 2011

Source: DBIQ and Bloomberg as of 21/10/2011.