With limited prospects for growth and expectations that inflation will continue to run below target, the European Central Bank (ECB) has signaled that policy rates are likely to be anchored at low levels for an extended period of time. As such, European bond yields are expected to remain low for a while.

Faced with the prospects of low or negative yields, European bond investors may conclude that there are no opportunities in European fixed income. We would disagree – European fixed income still offers the benefits that many investors seek from a bond allocation: diversification, capital preservation, and income. The present environment also offers opportunities for active managers to generate enhanced returns through utilizing active yield curve strategies, executing trading ideas derived from deep fundamental research or by using different market tools, such as futures.

Here are three such strategies that we believe may help investors now.

1. Yield curve strategies: Roll down the German curve

Although German Bund yields are at historically low negative levels, they still offer carry (potential return) of about 70 basis points, due to the steep shape of Germany’s yield curve. The Bund curve is steep relative to U.S., Japanese, and UK yield curves, especially between the 5- and 10-year maturities (see chart), and offers the ability to capture a structural source of return. The curve remains steep because the ECB is keeping short rates ultra-low, while the market still requires a premium for longer-maturity bonds. Investors can expect a steep curve to persist as long as ECB monetary policy doesn’t pivot dramatically and the ECB is able to maintain its long-term credibility.

The steepness offers the opportunity to “roll down the curve” – a strategy in which investors buy bonds at a steep point in the curve, benefiting from a price gain as time goes by and yields drop. For example, a 10-year bond will usually have a higher yield (and lower price) than a nine-year security. After one year, the 10-year bond price will increase as its yield decreases to the nine-year maturity point. This process can continue for a number of years, as long as the curve offers sufficient yield pickup between maturities, and also as long as the monetary policy regime does not change. The key for an active manager like PIMCO is to identify any risk of regime shift. At this stage we do not expect a change in regime given the current low growth and inflation backdrop.

2. Tap into overlooked sectors: Danish mortgages

In an aging expansion, characterized by low yields in Europe and tight spreads, we think it is more important than ever to emphasize sectors that provide resiliency and offer attractive risk-adjusted return potential. One example, in our view, is Danish mortgage-backed bonds. This sector has been a regular feature in PIMCO’s actively managed European portfolios because it offers a compelling yield above traditional government bonds, while keeping a low risk profile. Danish mortgage-backed bonds have been around for over 200 years without a single default and offer some of the highest yields in Europe, about 1.5% (euro-denominated), well above other AAA rated assets, most of which yield less than 0% for a similar duration risk.

The source of this additional yield pickup is the option embedded in these bonds: Borrowers have an option to call the bond at par every quarter. This creates uncertainty about the length of the investment, ranging from only a few years if prepayments are high to many years if they are low. This variability is directly linked to changes in interest rates, with prepayments increasing as rates fall and vice versa. In a scenario of stable monetary policy, though, and assuming no change in regime at the ECB, early prepayment should be a relatively low risk, allowing debt holders to invest in high quality assets yielding around 1.5%.

Danish mortgages have been overlooked by passive capital because they aren’t included in traditional bond indices. In our view, for investors able to model and understand prepayment risk, the additional premium provides ample compensation for the incremental risk taken.

Given these fundamentals, we believe Danish mortgage debt could be one of the more attractive European investments on a risk/reward basis.

3. Efficient replication strategies: Futures

As an active fixed income manager, PIMCO seeks to exploit structural inefficiencies in markets. One way to achieve this is by using derivatives – instruments that give exposure to asset classes, but that tend to be far more liquid and flexible than cash bonds (albeit with risks to manage). For example, instead of buying government debt directly, we often use futures, which can be traded in established exchanges, mitigating counterparty risk.

Derivatives can sometimes offer exposure more efficiently than the underlying asset – a mismatch that active managers may exploit. For instance, Bund futures are currently trading at financing levels that are lower than the level where an active manager can invest cash. This could be due to a variety of factors, including supply and demand or investor constraints. By purchasing futures, investors would then have the opportunity to invest the remaining available cash in high quality, short-term instruments with yields that exceed the financing cost of the bond exposure by a currently estimated 20 or 30 basis points (assuming no material increase in risk).

In summary, even in a low yield environment, an allocation to European fixed income may still make sense. Active bond managers have flexibility to tap into opportunities without taking significant added risk.