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Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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The most infamous bond trade: the Austria century bond.
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Investors have high hopes for the Austria 2120 bond. As deflationary pressures accelerate and growth remains sluggish, the ECB will begin cutting rates, pushing sovereign valuations upwards. Yet, the Austria century bond is paying a 2.3% yield, offering no pick-up over 10-year German Bunds. Although this instrument will undoubtedly benefit from a rate-cutting cycle, as the shape of the yield curve normalizes and investors take profits, a bear market might form in the ultra-long duration segment. For the Austria century bond to move back close to 100, one must assume that rates would drop around Covid levels. That is a bold bet in an ever-changing world where geopolitical tensions remain high and deglobalization is underway.
As discussed in a recent article, the consensus among economists is for deflationary pressures to accelerate in the eurozone this year, causing headline and core inflation to hit the ECB’s 2% inflation by mid-year, well before the central bank’s estimates. Such a move argues for an extension of duration as central banks get ready to curb interest rates early and aggressively. However, by how much should one extend the duration of their portfolio?
Concerning duration, Europe is an exciting playground because governments issued ultra-long-term sovereign bonds (30+) when interest rates were negative. In contrast, the US Treasury has never sold bonds with more than 30-year maturity. As the ECB aggressively hiked interest rates to fight inflation, the value of these securities plummeted, reaching distressed-like values. Yet, these bonds have nothing in common with distressed instruments because the price drop is not linked to one country's repayment capabilities but rather to the bond's structure.
The Austria century bond: a double-edged sword.
While it is true that each European country’s sovereign bond has a different risk profile depending on its economic fundamentals, some, such as Austrian bonds, have a risk profile similar to that of the Bunds. Therefore, investors can benefit from an additional pick up over the German Bunds while taking minimal additional risk compared to the European benchmark.
During the COVID-19 pandemic, Austria issued an infamous 100-year bond yielding 0.9% (AT0000A2HLC4). As the ECB deposit rate went from -0.5% to 4%, the bond price went from a €139 high to €33 low in October last year. Currently, the bond is trading at €42.
What's interesting is that while the Austria century bond was issued offering a pick up over the 10-year German Bund of 135bps and 90bps over the 30-year Bund (at the time, almost the entirety of Germany's yield curve was below 0%), since 2022 the spread between these three instruments compressed. Nowadays, they are offering approximately the same return. Yet, their risk profile is entirely different.
Austria's 100-year bond pays a 2.4% yield and has a modified duration of 46%. That means that for a 100bps increase or decrease in yield, the bond price moves by 46%. Germany’s 10-year Bunds (DE000BU2Z023) have instead a modified duration of 9% while Germany’s 30-year Bunds (DE0001102614) of 20%. Therefore, the Austria bond carries more duration risk than the other two.
The big question is: will the yield on the Austria century bond drop equally as the 10- and 30-year Bund yields once the ECB starts to cut rates? That’s a tricky question to answer because if we are assuming a steeper yield curve, then the Austria century bond should offer a considerable pick-up over bonds with shorter maturities.
Therefore, it is possible to envision two scenarios:
1- The drop in the Austria 100-year bond yield will lag the one of the 10- and 30-year Bund yields, resulting in a steeper yield curve.
2- The Austria 100-year bond yield will drop faster than the 10- and 30-year Bund yields, but it will soon enter a bear market as investors profit from this position.
The reasoning behind scenario number two is that as the ECB cuts rates aggressively amid a sluggish economy and diving inflation (as per consensus), real money might extend their portfolio duration drastically. They might look to secure the highest yield further away in the future, causing the ultra-long part of the yield curve to drop faster compared to other long-term tenors (10 to 30-year maturity).
Problems might arise when monetary policies normalize, and investors begin taking profit from their ultra-long positions. That would likely contribute to a bear market concentrated in the ultra-long part of the yield curve, which, if investors are unable to forecast timely, might result in losses.
For the Austria bond to return to €100, one must assume that rates would drop around Covid levels. In an ever-changing world where geopolitical tensions remain high and deglobalization is underway, that's a bold bet.
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