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Core issues confront eurozone investors

Few institutions embodied the eurozone crisis more clearly than Bankia, the Spanish lender which was bailed out in 2012. Yet you would have been hard pressed to see any signs of that as the lender tapped debt markets this month.

The bond sale by Bankia, still majority owned by the Spanish government, attracted almost €5bn in orders for the €500m of debt it sold. Its “tier 2” debt, which is exposed to the bank’s losses and counts towards its capital levels, was bought by investors with a coupon of just 3.4 per cent. By contrast, in 2012 yields on Spanish 10-year government debt traded at levels above 7 per cent.

“Bankia was a poster child of the banking crisis,” says Chris Telfer, a portfolio manager at ECM Asset Management. “Now its subordinated bonds are in high demand. Everyone wants to buy it.”

Bankia was not the only European lender to harvest bumper demand for its bonds last week, as sentiment warms towards the banking sector. However, the success of its sale was also the latest sign that a map dividing the eurozone between core, or stronger countries, and periphery, or weaker ones, needs an urgent overhaul if it is still going to help investors navigate the region.

As some countries that were hit hard during the crisis, including Spain and Ireland, sustain robust recoveries, and core countries such as France confront the risk of radical political change, investors and analysts say the distinction is now far less clear.

“Ireland was once very clearly periphery; now it’s very clearly semi-core,” says Nick Kounis, head of macro and financial markets research at ABN Amro. “It is fluid — no country can say that it will always be in one category or another.”

ABN Amro asked last week in a research report if Spain is set to become “semi-core”, concluding that the country was “not there yet” because of its large budget deficit. Nonetheless, Mr Kounis pointed to other positive economic fundamentals and the lack of “systemic risk” in Spain’s banking sector. ABN notes that, since 2014, Spanish GDP growth has averaged 2.6 per cent — outperforming all major eurozone countries except Ireland.

If Spain is moving closer towards the core, some investors have a sense of France edging the other way. ABN Amro currently identifies it as a semi-core country, alongside Ireland, Austria and Belgium.

Ten-year sovereign bond yields in France have moved higher this year as the market refuses to rule out a shock victory for anti-euro candidate Marine Le Pen in April’s presidential elections. They touched 1.1 per cent in February — their highest level in more than a year. In the same month, core yields in Germany and the Netherlands hit their lowest levels to date.

How the bonds of other periphery countries have reacted to the emergence of political risk in France also shows how traditional definitions of what is risky and not within the eurozone are changing, say investors.

The market perception of political risk in France has, for example, correlated much more closely with Italy, which is still much more strongly associated with the peripheral label. In February, the Italian 10-year yield hit 2.4 per cent, its highest level since the summer of 2015. “Spain has been viewed less and less as a peripheral pick,” argues Mr Telfer. “With the French weakness you had Italian weakness, whereas Spain hasn’t widened to the same extent.”

If politics and a divergence in economic performance is blurring the once stark distinction between core and periphery, central bank policy continues to pull in the opposite direction. The European Central Bank’s purchases of sovereign bonds — amounting to almost €1.4tn as of late last month — have deliberately forced down yields across the board.

Indeed, the pressure over the past year on Portuguese bonds illustrates the influence that the central bank commands. While fund managers have been concerned over the country’s economic performance, it is fears that a change to Portugal’s credit rating from Canadian agency DBRS could remove it from the ECB’s bond-buying programme that has been the bigger factor.

“That in itself reveals quite a lot about why spreads are where they are,” says Adrian Hilton, a portfolio manager at Colombia Threadneedle.

“This big tightening we’ve had since the eurozone crisis, and more notably since the start of QE, has really blurred the distinction,” he adds.

However, the compressing effect the ECB has had on borrowing costs between the eurozone’s historically core and periphery countries may start to ease should higher inflation and an improving eurozone economy raise tougher questions about the future of its bond-buying programme.

The ECB has already said it will reduce its purchases from €80bn a month to €60bn from next month. The gradual withdrawal of ECB support — and the higher bond yields that would follow — could yet force investors to put the distinction between core and periphery back in the bold letters that dominated during the crisis.

With few signs of Italy’s banking woes going away, the country could find itself at the sharp end. “It would not take too much in terms of a growth shock or interest rate shock to make Italy’s dynamics look quite alarming,” said Mr Kounis of ABN Amro.

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