Fixed Income in an Evolving Europe: Can You Measure the Permanent Impact of the Eurozone Crisis?

João Sousa Dias, Solutions Specialist, Eagle Investment Systems

Financial and political events since the onset of the financial crisis in 2008 have redefined sovereign risk in the eurozone. The disruption and its lasting impact has left fixed income investors searching for answers when it comes to measuring their “true” European exposure and determining the appropriate government yield curves to benchmark against. Many existing portfolio analysis and performance attribution platforms struggle to accommodate the new paradigm, which requires a new approach to fixed income performance reporting.

Background to Risk Free Bond Markets
Until the financial crisis, government bonds of developed countries were considered to be largely risk free. This was based on a number of conditions, including the assumption that developed sovereign nations were unlikely to default and that their control over currency meant they could print more money to service their debt pile as required. For eurozone members, however, the situation is different. Individual nations, in joining the eurozone, effectively gave up control of the money supply to the European Central Bank (ECB). The result is that multiple government yield curves now exist within a common currency. During the decade of relative stability that followed the introduction of the euro in 1999, the eurozone was largely treated as a single entity when it came to financial risk. The financial crisis, as fixed income investors have discovered, has challenged that with widening spreads between member nations and increasing volatility in debt prices from country to country.

The New Paradigm
All of this was brought into sharp focus again in June when the Greek sovereign debt crisis resurfaced and the government failed to make its IMF loan repayment—the first developed country to ever do so. Since then, yields on Greece’s 10-year government bonds have been running at over 10%. This compares with less than 1% for German bonds. Furthermore, this latest turn in the crisis has undermined the assumption that the eurozone collectively will bail out the sovereign nations within it. With the risk of default—coupled with no control over interest rates and currency printing—the European government debt market more closely resembles the corporate bond market.

As a result, the sovereign risk-free debt landscape within the eurozone countries has fundamentally changed, leading to a paradigm shift with the introduction of new implied risk-free benchmarks. This reality, however, isn’t necessarily reflected in the analysis of fixed income portfolios in European sovereigns, as most legacy performance and attribution platforms are not readily able to support the kind of analysis now required.

Challenges in Calculating Performance in the New Environment
Depending on an investor’s portfolio strategy the shift toward more volatile debt prices and greater spreads across the eurozone may also necessitate the use of different yield curves when it comes to analysis and attribution. Further, the definition of what the EUR risk free rate is can vary: Some use the German bond rate, while others use a mix of the lowest points. Those with country specific portfolios will almost certainly need to perform analysis and attribution on the basis of individual country curves. Moreover, dedicated European corporate debt portfolios might use an analysis that incorporates individual country curves to decompose holdings into nation-specific return and corporate spreads, abandoning the common risk-free eurozone curve. This multi-yield curve approach poses challenges to many performance attribution platforms where, typically, yield curves are linked at a currency level.

How Eagle can Help
With its comprehensive attribution framework, Eagle enables multi-yield curve analysis linking at an instrument—i.e. country and per asset—level providing greater accuracy on the sources of fixed income performance. Rather than use a single aggregated yield curve, investors are able to set the appropriate curves for each decomposition, enabling a more accurate analysis accounting for each country-specific interest rate environment. Both existing and future Eagle clients alike are able to benefit from these tools that ensure performance measurement and attribution is tailored to the portfolio strategy.


In Brief

Risk free environment

  • Government bond curves considered risk free in developed countries
  • Risk free as theoretically government can print money and unlikely to default

The situation in eurozone

  • Money supply handed over to the ECB
  • Eurozone treated as a single entity
  • Single currency zone has multiple government yield curves
  • Financial crisis exposed

The new paradigm in the eurozone

  • High spreads between eurozone countries
  • Volatile debt prices and spreads between countries
  • Negative interest rates
  • Government debt similar to corporate debt

What this means for calculating yield curves

  • Depending on portfolio strategy, different curves might be required
  • Defining EUR risk free – Germany or mix of lowest points
  • Country-specific portfolios need individual country curves
  • Corporate debt portfolios need to decompose country returns into nation-specific returns and corporate spreads

How Eagle can help

  • Multiple curves defined at instrument level allow for better analysis
  • Platform for analysis that copes with the new normal
  • More accurate view on sources of fixed income performance
  • Set the appropriate curves for each decomposition
  • Better analysis of interest rate environment
  • Performance decomposition tailored to portfolio strategy

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