This article is no way an attempt to scaremonger any investors already exposed to European sovereign bonds or those prospective investors who are contemplating building exposures to European sovereign bonds in one way or another, directly or indirectly either via a Collective Investment Scheme or an Exchange Traded Fund.

It is merely intended to outline the salient risks of being exposed to European sovereign bonds, and clarify the misconception that an investment in government bonds is safe, secure and free of any risk and that an investment in this asset type within the fixed income asset class can be considered to be anything but equivalent to cash holdings and must not be treated as a short-term vehicle to park monies.

Past performance is not a guide to future performance. This phrase is widely used in disclaimers within the investment space, be it in advertorials, marketing material, investment application forms, etc., and this phrase cannot be more real and correct for European sovereign bonds in the current prevailing market scenario.

Sovereign bonds are on the back of what can be considered a 30-year rally, so yes in hindsight one could have safely said that sovereign bonds were a safe investment play. But with yields so low, and inflationary expectations in the Eurozone picking up, albeit marginally, we could well be at an inflexion point whereby rates begin their upward trajectory.

Two of the key risks pertaining to an investment in a European Sovereign bond is credit risk (the risk that the bond issuer/government defaults on its financial obligations with the bondholder) and interest rate risk (the risk that interest rates fluctuate and adversely impact the price of the bond).

Although it is by no means accurate, as credit risk is an integral part of a bond’s underlying risk (although bonds for example in core Europe are ultra-high grade in terms of credit quality), let us assume that credit risk for sovereign bonds is inexistent and interest rate is the primary source of risk in Sovereign bonds.

Since September 2016, volatility in bond prices, particularly at the longer end of the curve, prevailed in a market which had, for the previous 30 years seen long stretches of gains and rallies.

Investors were not used to seeing sovereign bonds fluctuate so much, and, even more so, seeing large chunks on gains which had been accumulated over the years be eroded in such a short period of time. And the proper unwinding of the Quantitative Easing trade in the Eurozone is still in first gear.

This resulted in investors becoming edgy and closing off some of their holdings. Following the end of year sell off in sovereign bonds, yields stabilised but in recent weeks, yet another sell off ensued.

Long-dated bonds sold off as much as 350bps in a span of just two weeks, that’s on average the weighted average coupon for example of outstanding Malta Government Stocks on issue, equivalent to a year’s worth of interest. Not much a safe bet for those investors who think that European sovereign bonds are free of risk and have their minds at rest with their monies ‘parked’ in government bonds.

Now, more than ever, a portfolio of government bonds needs to be dynamically managed. Interest rate risk must be lowered, as hawkish comments by central bankers were not immune to this movement.

The market interpreted comments by ECB’s Draghi and the Fed’s Yellen and Carney to signify that a tightening policy in both regions is warranted and possibly on the cards in the months ahead, which resulted in a sharp sell-off in sovereign bonds.

It is apparent to us that the moves we have seen towards the end of June is merely a taste of what volatility and subsequently bond performance could be like once the ECB announces a further QE reduction.

Having said that, I am still of the opinion that sovereign bonds do have a place in a well diversified and actively managed bond portfolio. This naturally depends on the underlying client’s investment objective and risk tolerance, but I am more than sure that, to a number of investors, the word ‘risk’ has taken on a completely new dimension as the chances that they were oblivious to market risk related to European sovereign bonds before reading this article could be quite high.

Disclaimer: This article was issued by Mark Vella, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.