European QE Draws Attention to Irish Bonds
Europe’s bond markets are starting to focus on the potential impact of ECB sovereign-bond purchases. While we expect QE to prompt a further narrowing of peripheral European sovereign-bond spreads, it’s important to stay focused on country fundamentals when selecting exposure.
We’re expecting the European Central Bank (ECB) to launch a broad-based quantitative easing (QE) program—including sovereign-bond purchases—early in the new year. This could happen as soon as the next policy meeting on January 22.
The end-result of ECB bond purchases is likely to be a general lowering of bond yields across the region and a further narrowing of peripheral Europe’s sovereign-bond spreads. Bond markets are already starting to price in this scenario and we’ve seen the spreads of most peripheral countries tighten to multi-year lows (except Greece in the wake of its recent political instability). We continue to believe that selected exposure to peripheral sovereign debt can represent an attractive component of a well-diversified global bond portfolio. At the same time, we think it’s critical to gauge the economic health of the various euro-area states and determine whether country fundamentals are truly reflected in the chosen peripheral exposure. A favorable fundamental backdrop can contribute to improved idiosyncratic performance and give us greater confidence on a longer-term investment horizon.
Why Irish Eyes Are Smiling…
When we look at euro-area economic fundamentals, it’s clear that Ireland is bucking the region’s generally downbeat trend. As a whole, the region grew by just 0.8% year-over-year in the third quarter, but Ireland notched up an impressive 3.5% growth rate (Display). Ireland’s recovery appears to have decoupled from the rest of the euro area, boosted by its strong domestic rebound and its trade links with faster-growing markets, like the UK and the US.
At the same time, Ireland’s tough fiscal and structural reforms are working and the government has continued reducing its fiscal deficit. As a result, Ireland’s debt-to-GDP ratio is declining in a meaningful way and we think this trend is set to continue (Display). This is not something we expect to happen in most of the rest of the periphery—or, in fact, in some of the region’s larger economies. France, for example, is still seeing its debt-to-GDP ratio trending higher.
Ireland’s growth dynamics and favorable debt trajectory have resulted in credit rating upgrades. Earlier this month, S&P upgraded Ireland to A and we expect this upside for Ireland’s ratings to be maintained. Over the medium term, Ireland’s ratings could well converge with those of the lower-rated euro-area core countries—like France and Belgium. While Irish government bond spreads have tightened this year, the 10-year still trades some 60 basis points wide of equivalent French or Belgian debt. In our view, given Ireland’s favorable fundamental outlook and improving creditworthiness, this spread should narrow over time. And the compression trend could well be hastened when ECB QE begins.
By contrast with Ireland, many of Europe’s other peripheral economies continue to face significant challenges. Italy is one notable example. Indeed, S&P recently downgraded Italy’s credit rating to BBB- because of its worsening growth outlook and high public debt. While we think Italy’s bond spreads will be anchored by ECB policy, and will likely also see further tightening, we’re more positive on Irish bonds than their Italian counterparts because of the sovereigns’ diverging fundamental fortunes.