European markets have come a long way since the historic debt-crisis which resulted in the collapse of several financial institutions, massive government debt burden and fast-rising bond yields in government securities.
The European sovereign debt crisis originated in 2008 after the breakdown of Iceland's banking system, and spread like wildfire to other Euro zone nations with Greece having defaulted on its debt in 2012. Recession and deflation became the tags of Euro zone.
However, since then, the European Central bank did a lot to save the common currency Euro and jump-start growth in the bloc through bailout funds and easy policy measures.
Stringent austerity measures also played a role in bringing some members of the Euro zone back on track last year. However, while the continent started taking baby steps toward self sufficiency, worries over deflation cropped up.
ECB’s Latest Action
To fight the worries, the ECB left the global market in utter shock by establishing a negative interest rate in early June. The central bank slashed its benchmark interest rate from 0.25% to 0.15% and lowered the deposit rate from zero percent to -0.1%. The ECB was the first major central bank to resort to such steps.
While an extremely accommodative ECB shifted investor preferences to higher risky asset classes, a rock-bottom interest rate environment has spurred the appeal for a regular source of current income as well.
This new-found optimism pushed down the bond yields drastically lower which in turn pushed up bond prices. As of June 17, 2014, Euro area yield stood at 1.582%, down from 3.352% noticed on the same day three years ago (read: 3 European ETFs to Buy After ECB Action).
Laggards Come into View
Bond yields at many of the weaker nations like Spain, Italy and Ireland plummeted to record lows in May, as per Bloomberg. Two laggards – Greece and Spain— received an upgrade in credit rating from the S&P.
The Spanish economy expanded the most in six years in the first quarter of 2014. Thanks to the showing of solid improvement, Greece also came out of the four-year market borrowing expulsion and issued five-year bonds in April (read: What is Behind the Greek ETF Surge?).
Ireland has also been accredited a credit upgrade from the S&P. Ireland's long-term foreign and local currency credit rating is now elevated to A-minus from BBB+ on the back of an improving global economy and positive signs of recovery in domestic economy (read: Ireland ETF in Focus on S&P Upgrade). Last month, another rating agency – Moody’s – upgraded Ireland’s credit rating on government bonds by two notches to Baa1 citing improved outlook for Irish debt.
The average yield to maturity on bonds from Greece, Ireland, Italy, Portugal and Spain dropped the most to 2.19% on April 23, putting their bond yields at ultra-low levels. In fact, Irish borrowing costs are now below that of the U.S. for the first time in more than five years while Spanish 10-bonds are yielding lower than U.S. bonds after four years.
A lot of European bond ETFs gained out of this hope in the recent past. Dirt-cheap valuation of these products also helped these to generate substantial gains in the last one-year period.
WisdomTree Euro Debt (EU), PowerShares DB German Bund ETN (BUNL), ProShares German Sov/Sub-Sov Debt ETF (GGOV), PIMCO Germany Bond Index ETF (BUND) and PowerShares DB Italian Treasury Bond ETN (ITLY) added about 7.67%, 5.24%, 5.62%, 3.53% and 16.97% over the last one-year period (as of June 18, 2014).
These returns compare favorably with the 0.32% return offered by the U.S. short-term treasury iShares 1-3 Year Treasury Bond (SHY), 3.74% return out of SPDR Barclays International Treasury Bond ETF (BWX) and 0.28% loss incurred by iShares 7-10 Year Treasury Bond (IEF).
Now with the Federal Reserve slashing the growth forecast for the U.S. and vowing to keep the interest rates low for longer despite the QE wrap-up, European bonds might find it tough to outperform their U.S. cousins in the coming days. The Fed reduced its long-term estimated rate to 3.75% from 4.0%, as per Bloomberg. Following the announcement, the U.S. treasuries advanced.
Secondly, the public debt-to-GDP ratio remains pretty high at this stage with Greece (175.1%), Ireland (123.7%), Italy (132.6%), Portugal (129.0%) and Spain (93.9%) being some of the highest debt-laden nations.
In fact, leading nations like the U.K. (90.6%), Germany (78.4%) and France (91.8%) also do not fall far behind. With economic stability still to reach the pre-crisis level, a lingering concern of credit default cannot be solely ruled out.
Thus, investors need to be vigilant over every move in the global market though the ECB’s recent action and more possible policy easing, if required in the future, should shore up this undervalued investing corner of the world in the near term.
Which One to Play the Space?
To make some choices, we would like to go for EU at first as the fund is highly exposed to better-positioned economies like Germany, Luxembourg and Belgium. Apart from this, bond ETFs based on Germany can also be good choices for risk-averse investors as the nation is one of the most stable in, not only the Euro zone, but the globe as well.
Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report >>