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Investors in German bonds face conundrum over Europe's safest asset

Economic recovery, regional stimulus suggest upcoming higher bund yields but those shorting them in the past have been badly burned


THE rally in German bonds in the past week has reminded fund managers why betting against Europe's safest assets is a risky business.

The debt slid last month as economies showed signs of recovering from the ravages of the novel coronavirus pandemic, leading some analysts to predict yields would soon turn positive after a year below zero. Instead, worries over a second wave led investors to dump stocks and turn to havens such as bunds.

Now, funds are in a quandary. An economic recovery, increased German borrowing and regional stimulus are all factors that suggest higher bund yields down the road. But those shorting bunds in the past have been badly burned, and for some, German debt is just not worth touching.

"We have no position in bunds," said Patrick Armstrong, chief investment officer at Plurimi Wealth LLP. "Don't see the attraction of owning negative 0.3 per cent, but not a good level to short."

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While the negative yields mean investors lose cash if holding the debt to maturity, traders can make money if it keeps rallying. That has led German bonds to return more than 7 per cent since the start of 2018, through the turmoil in Italian politics and Brexit, trade wars and the pandemic, according to Bloomberg Barclays indices.

They serve as a proxy for European risk, and tend to rise on concerns about the stability of the euro area. So the huge European Central Bank (ECB) asset purchases and a plan to jointly issue euro debt provides stability and a new challenger - something that money managers have not had to deal with before.

"Investors could substitute for bunds with the new European Commission issuance," said Ross Hutchison, an investment director in Aberdeen Standard Investments' fixed income team. "We think central bank support will keep yields low, but we don't think bunds are an attractive place to hold these overweights right now."

Still, with the risk of a second virus wave and central banks vowing to do whatever it takes, investors are grabbing longer maturity returns wherever they can. Demand for European sovereign debt sales via banks last week topped US$300 billion.

Germany initially pulled in more than US$50 billion of bids for its sale of 30-year bonds, the only tenor offering positive yields, allowing it to cut pricing on the deal.

"What makes bunds unique amongst other defensive assets is that they offer investors downside protection specifically against a break-up of the euro area," said Wolfgang Bauer, a fund manager at M&G plc. While demand for such a break-up hedge has been reduced, he "wouldn't write bunds off just yet".

The bloc's groundbreaking issuance plan is not confirmed yet. There are signs that northern European nations could revolt, with Austria the latest nation to declare its opposition, not wanting to be on the hook for rebuilding badly-hit southern countries.

All sorts of supportive global risks are lurking. These include the chances of a no-deal Brexit this year, the resumption of US-China tension and the US election.

That could be good for Mark Dowding, chief investment officer at BlueBay Asset Management, who is adding exposure to bunds because he expects the ECB to hold yields down. But even he is not feeling particularly enthusiastic.

"To be honest, we have no strong conviction," he said. "Ultimately, we think yields aren't really going anywhere." BLOOMBERG

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