Eurozone public debt yield fell by 13% in 2022

After the first half of record losses, investors in the European bond market generally agree that the worst could end. Few, however, say that now is the right time to return.

Concerns about inflation and the region's growth prospects cloud the picture, leaving many wondering. While Invesco says it's time to start returning to the market, Carmignac believes it's too early. AllianceBernstein fluctuates, even though the stakes look much more attractive after years of thin plate returns. 

"Yields are now back to levels where people start allocating funds to fixed income again," said Vivek Bommy, head of European fixed income at AllianceBernstein, which manages $735 billion in assets. But the firm expects further inflation data before it starts buying in size. "The best entry point will be later this year," he added. 

Caution isn't surprising after the first-half rout left investors in European bonds at a loss of 13 percent, the worst start to the year on record to date, according to the Bloomberg Index, which tracks euro zone government bonds. More than 870 billion euros ($911 billion) have been erased from the value of the index this year. 

The outlook in Europe is bleaker than in other regions, in part because the European Central Bank has yet to raise rates to cope with record inflation, while several countries are in their upward cycles. A lack of clarity on the scale of rate hikes is likely to continue to weigh on the region's bonds, which have fallen sharply after the ECB signaled plans to move away from its long-standing ultra-loose monetary policy. Volatility, as measured by swaps, has also risen and is close to its highest level since the global financial crisis. 

The market will be "struggling to find balance" until the ECB starts raising rates and there is "more clarity on expectations of terminal rates," said Steve Ryder, sovereign portfolio manager at Aviva Investors.

While euro zone bond yields have fallen since ECB President Christine Lagarde quelled the nascent Italian bond crisis in June, vowing to counter market speculation, many investors are reluctant to buy if policymakers take a tougher stance than expected to deal with the inflation shock sweeping the region.

Some, such as Carmignac fund manager Guillaume Rigueade, believe that yields continue to rise, although not to the same extent as before. Rigeade sees a further rise in inflation until the autumn, after readings for France and Spain reached new highs this week, and the blunder in Germany was due to government intervention. 

"We think it is extremely optimistic to think that the ECB can kill inflation in a year," he said. Ridgeid believes the drop in inflation expectations, measured by break-even and forwards, is premature, and is positioning his fund to take advantage of it.

However, this year's brutal sell-off in the bond market has faded amid expectations of an impending economic slowdown. For example, ten-year German rates fell below 1.4% after rising to 1.9% in mid-June, the highest level since 2014. Yields on equivalent Italian bonds also fell after soaring above 4%, weakening after the ECB promised a new tool to mitigate excessive panic in government bond markets.

Further details on the instrument, still scarce at the moment, are expected alongside the ECB's july 21 policy decision, when it will almost certainly raise rates by a quarter point to minus 0.25%, the first increase in more than a decade. But some are concerned that this tool will not be enough to prevent Italy's spread from widening on German debt again.

"We are not confident that its plans for the new instrument will be sufficient to contain the widening of spreads, given the weaker fundamentals affecting credit as a whole," Societe Generale strategists wrote in a recent note. They see Italian bonds trading at as much as 300 basis points compared to German equivalents by the end of the year, up from about 190 basis points currently. 

Borrowing costs from major countries may also come under new pressure. In a bearish scenario where Brent prices rise to $150 a barrel, the yield on 10-year German bonds could reach 2.75% by the end of the year, more than double current levels, according to Morgan Stanley strategists. This contrasts with their baseline case of about 2%.

Indeed, faced with persistent uncertainty about the outlook for inflation and the ECB's response, the next few months will remain challenging for investors. Aviva's ryder is poised to go overweight government bonds – but not yet. Still, he voiced a note of optimism. 

"After unprecedented losses in the first and second quarters, we believe the bulk of the negative returns are behind," he said.