Brexit Makes Money for Investors Ignoring Risk to European Bonds

(Bloomberg) -- Brexit is turning out to be a blessing in disguise for some of the European bond markets that were expected to be among the biggest casualties.

Rather than hastening the disintegration of the European Union, the U.K.’s vote to leave the bloc two months ago has triggered a different collateral effect, at least for the meantime, as investors expect the European Central Bank to add stimulus to shield the region from any economic fallout. The result has been that government securities from the most indebted countries have led gains across the euro region.

“People talked about possible domino effect on the euro zone after the U.K. voted to leave the EU,” said Cosimo Marasciulo, head of government bonds at Pioneer Investment Management Ltd., which has more than $240 billion in assets and bought the so-called peripheral debt after the referendum. “We took the opposite view. The euro zone was more resilient to any Brexit shocks than envisaged by many because of the ECB policy.”

Brexit Makes Money for Investors Ignoring Risk to European Bonds

While yields initially jumped in the aftermath of the June 23 vote, the moves soon reversed, with those on Spanish bonds falling to records in August, even as the country struggles to form a government. Italy, which faces a banking crisis and a divisive referendum of its own in October, also rallied.

Spain’s government bonds returned 3.8 percent since the Brexit vote, the best performers among major euro-area markets. Italian debt earned 2.4 percent, while benchmark German securities gained 1.4 percent. Even bonds in Ireland, the economy in the euro region that’s most exposed to the U.K., advanced 2.3 percent.

ECB Shield

Brexit is the latest political risk to the euro region, from inconclusive elections to Greek wrangling over its debt, to trigger warnings about the effect on markets only to ultimately leave bonds unscathed as the ECB smothers all potential turmoil. While the ECB’s Governing Council refrained from any changes in a meeting in July, President Mario Draghi stressed a “readiness, willingness, ability” to act if needed.

An increased scarcity of bonds eligible for the purchases has also prompted speculation that the central bank may review the program’s rules. Changes would likely favor the region’s higher-yielding securities, according to analysts.

“It’s simply a case of monetary policy action,” said Anthony Doyle, investment director at M&G Group Plc in London. “The ECB has weighed in very heavily into the government bond markets through its asset purchase program and it’s likely to expand that in September.”

Political Support

Years of low interest rates and bond purchases by central banks across the world suppressed yields and prompted investors to eek out returns in riskier markets. The yield spread between Spanish 10-year bonds and German securities fell below 100 basis points, or 1 percentage point, on Aug. 18, a level not seen since December.

That’s even as Spain’s caretaker prime minister, Mariano Rajoy, faces a confidence vote in a highly fragmented parliament after almost eight months of deadlock. If he fails, the country will have a third election in a year. Italian premier Matteo Renzi meanwhile has said he would quit if voters reject his plan to overhaul the political system.

Despite “politics being still up in the air” in these countries, the ECB’s stimulus and recent messages from other European institutions suggest increasing support for the euro project after Brexit, according to Robert Tipp, chief investment strategist for the fixed-income division of Prudential Financial Inc. in Newark, New Jersey. The European Commission decided not to penalize Spain and Portugal for missing budget targets in July.

The review of the deficit violation shows the commission is “accepting slow progress” instead of putting pressure on them, while the ECB is adding support through monetary policy, Tipp said. “That trumped the Brexit risk.”