Fears of a possible Greek sovereign debt default are, we believe, overstated, given the distinct possibility that Greece may receive European Union (EU) support in one form or another.
The demand from premium investors to hold Greek 10-year government bonds over German benchmarks rose to more than 390 basis points on January 28, 2010 after France and Germany initially said they were not planning an EU bailout for Greece. In addition, high-ranking European Central Bank (ECB) officials have been adamant that there would be no bailout of Greece. Not surprisingly, by the end of January, the euro had fallen to a six-month low against the US dollar on worries over the public finances of Greece and other small eurozone countries.
A Greek default on its debt commitments could have a domino effect on other European countries – something European politicians will be keen to avoid. A bond offer by Greece in early January was heavily subscribed by investors (although it paid a high price), and an emboldened Greek government later said it would sell more bonds in February. And Greek bond spreads over German Bunds narrowed in early February after EU policymakers backed new plans from Greece to boost tax revenues and cut public spending. There is also a distinct possibility Greece will receive European Union (EU) support, with the French and Germans potentially taking the lead despite their earlier reluctance.
Nevertheless, bond markets in a number of 'peripheral' European countries – including Greece – seem likely to continue enduring sharp swings in prices for some time to come because of weak public finances, in our view. Recent events underscore the concern that many investors have about the robustness of a lasting economic recovery in Europe. The cautious and (some may say) non-accommodative approach of the ECB, the fragmentation of European government bond markets, deficit disparities among EU member states, the continued high rate of unemployment and the still-troubled banking system are all factors that we believe may cause growth in the region to lag for some time to come.
In light of the progressive recovery of the US economy, as well as the difficulties of individual euro zone countries and their long-term structural problems, the euro could remain weak against the dollar and even against UK sterling. For these same reasons, we believe interest rates in Europe may remain low for longer than in other regions, and thus we have been building positions in longer-dated European government debt.
Elsewhere, it will be difficult to repeat the same double-digit returns in corporate credit seen in 2009, given the low interest-rate environment and narrowing spreads between corporate and government bonds. Yet we still believe corporate credit may continue to outperform government issues. Thus, we remain overweighed in corporate debt relative to government bonds, especially bank debt – not because we believe corporate yields are going to drop, but because we think government bond yields seem likely to rise.
-The writer is the Senior Vice- President and Portfolio Manager, Franklin Templeton Fixed Income Group. The views expressed are his own
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