Don't Get Too Carried Away With European Bonds, Be Selective

(Bloomberg) -- The European Central Bank playing for time and acknowledging the slowing momentum in the region’s economy continues to support carry trades. But don’t jump blindly up the credit spectrum in euro-area government bonds, be selective.

While Italian bonds offer the most attractive outright carry and roll, adjusting for volatility puts Spain and Portugal on top. Looking through that lens is necessary because earning carry assumes an unchanged yield curve, which is implicitly being short volatility, and that can evaporate quickly.

Don't Get Too Carried Away With European Bonds, Be Selective
  • The Italian front end offers the largest three-month carry and roll in EGBs, but loses its allure on a volatility-adjusted basis, with the weak Italian data trend raising the bar for significantly tighter spreads, especially in the face of higher issuance and elevated political risks
  • While underlying momentum is softening across the euro bloc, Spain 3y-7y and Portugal 5y-7y offer the most attractive vol-adjusted carry profile, while having a relatively more supportive issuance outlook and lower short-term political risks compared with Italy
  • Portugal should also benefit from net QE buying related to the ECB converging to the new capital key, where it is underinvested by ~EU10b, while being overbought in Italy, Spain and France
  • The pursuit for short-term carry given the weak data trend and historically low levels of implied vol can also be extracted from EUR vanilla receiver swaptions (with risk reduced to premium while being long convexity), long-end single-look spread caps that roll down positively and receiving optimal points of the EUR forward swaps grid
Don't Get Too Carried Away With European Bonds, Be Selective
  • NOTE: Tanvir Sandhu is a global interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

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