Shorting Italian government bonds while buying their French counterparts is how one absolute-return bond manager has responded to the countries’ differing outlooks.
James Lynch has made the “alpha” trade in his own Kames Absolute Return Bond Constrained Fund, which he co-manages at Kames Capital alongside Euan McNeil.
His short position follows the rejection in Italy of a referendum to carry out constitutional reform.
“We think Italy is facing both short term and long term difficulties, and indeed, in the near term Italian fundamentals appear to be deteriorating,” he said.
Following the rejection of the referendum, it is now harder to carry out the economic reforms that Lynch said the country needed, which in turn meant bond investors would need a higher rate of return, hurting Italian debt, he said.
Political reform in France, meanwhile, will “either be extremely profound or non-existent depending on who is elected president”.
A mainstream election would lead to the possibility of some reforms, benefitting French debt, while a Marine Le Pen, of Front National, victory would force the focus on a possible withdrawal of France from the EU.
“Ultimately, when the market has to price an increase in such an outcome it should be much worse for Italy than France because of its current weakness. Italy’s debt dynamics are in a worse state by far than France’s, and in the event of an EU breakdown the market would seek out the weakest links in the system (the periphery and Italy) and focus their attentions on them,” Lynch wrote in a note called ‘Two eye-catching alpha trades in fixed income markets’.
The short-Italy, long-France trade is one of two that Kames’s bond duo have placed in recent weeks.
The other is to go long on US Treasury Inflation Protected Securities (Tips).
“Tips are directly linked to how much inflation rises or falls in the US, and thus the more inflation rises, the more these Tips become valuable assets. In comparison, with nominal treasuries you are locked into the return which can be eroded by inflation,” said Lynch, adding that a rate of inflation in the US of 2.5% “looks reasonable”.
©2017 funds europe
