German Bunds still face pressure relative to risk-free rates

There had been a general sense that the central banks’ quantitative tightening paired with ongoing high funding needs would require a reassessment of sovereign spreads – both relative to each other and versus “risk-free” rate expectations. This is a theme not exclusive to European government bonds but also observed in US Treasuries and Gilts.

However, what was a gradual underperformance of eurozone government bonds versus swaps led by Bunds suddenly accelerated early in October and turned into a vicious repricing that had repercussions across the wider EUR fixed-income market.

The poor performance of Bunds has raised concerns since they usually serve as a benchmark for the wider sovereign and sovereign-related bond market. Many have raised the spectre of valuations similar to those in the US or UK, where 10y government bonds trade around 50bp above OIS. We do not see such levels as a target for 10y Bunds anytime soon.

What sets Bunds apart is that they are just a small slice of the wider eurozone bond market, less than 20% of a €9.6tr market. But importantly they are still the highest rated slice with liquidity underpinned by a futures market. If we take the weighted average spread of 10Y eurozone government bonds versus OIS, we are already at cheaper levels compared to the US and UK.

Fan out the spectrum across the ratings and liquidity of the eurozone market and there is good reason for Bunds to trade at a premium. Bund valuations have stabilised and even recovered somewhat in recent weeks, mainly on the back of geopolitical risks in Eastern Europe flaring up again and also political tensions rising in France. But it is also worth pointing out that the 10Y Bund spread versus OIS peaked at levels last seen around 2014 just before the European Central Bank started buying government bonds.  

Pre-QE levels may serve as a first anchor point but the structural headwinds to sovereign valuations persist – foremost in the form of the large volumes that private investors will have to absorb going forward as issuance plans remain elevated and the ECB no longer reinvests redemptions from its bond portfolios.

Another cyclical factor also looks less likely to turn favourable anytime soon – the ECB will remain in a rate-cutting mode, which means that net flows on the swap leg of the spread should remain biased towards receiving. Additionally, at the long end of the curve, the prospect of receiving flows from Dutch pension funds looms large – on the back of indexations and going forward in preparation for transitioning to a new pension system.

The uncertainty around the German political backdrop could pose another headwind to Bund valuations versus swaps early in the year. Snap elections are scheduled for February after the current governing coalition broke apart over the budget and the handling of Germany’s constitutional debt brake. We doubt there will be big impacts on near-term spending solely from this. Reforming the debt brake will take time, but if the increased spending is ultimately directed towards investment, it could positively impact the long-term outlook of the German economy. If any country has the capacity for more investment spending, it is Germany.

The very front-end provides the most important anchor though, where the 2y Schatz has been more range bound since November at 7-12bp above OIS. In money markets, the pricing of German collateral in repo markets seems to have stabilised at levels around 5bp above the overnight ESTR rate, having already come off a peak at around 10bp in late September through early October. Some of the accelerated underperformance versus swaps further out the curve was indeed triggered by the repo market’s term-premium adjusting to these spot levels as the pricing over the year-end failed to repeat the rich valuations of past years.

For spreads further out the curve such as the 10Y Bund, we think this argues for some stabilisation at levels around 10-20bp above OIS (5 to -5bp around IRS) with risk-on/off episodes mainly driving the deviations towards flat and below swaps again. Bunds should always have a place as a portfolio diversifier to hedge against unforeseen events and recent events have shown that the reflexes still work in the right direction.

Going forward, we see three main sources of such risks – geopolitical risks, eurozone political and sovereign risks and macro outlook risks – although the episode around Silicon Valley Bank of early 2023 also shows how other events can quickly lead to a larger outperformance of Bunds.