Waxing and waning interest in bonds

The behaviour of fixed interest investments has been unusual this year. Base rates have been rising in many developed economies, notably the UK and US, but unusually bond prices have rallied. US treasuries have risen by 3.8 per cent in price this year while UK gilts have increased by 4.6 per cent and eurozone government bonds have gone up 5.7 per cent. From the end of June to the end of September, for example, yields on German 10-year bunds fell from 4.44 to 3.94 per cent.

There are several possible reasons for the increase in bond prices in Europe and the US. It is partly due to greater allocations by pension funds and insur�ance companies towards long-dated bonds and away from equities to match their long-term liabilities. Also, concerns about a slow down in econom�ic growth and corporate earnings and the low cost of borrowing mean bonds are still attractive to leveraged investors.

Reduced expectations

European bonds have also been helped by a softening in expecta�tions over the likelihood of the Euro�pean Central Bank raising interest rates.

In the 12 months to October 1, 2004, the Citi European WGBI index returned 11.41 per cent. The index has delivered a return of 61.81 per cent over the past three years and 56.94 per cent over the past five years. Interestingly, of the 10 largest European fixed interest funds sold cross-border, only one has out�performed this index over the past year.

These funds, however, have different mandates and levels of flexibility in terms of how far down the credit risk they can invest.

While government bond prices have risen in Europe this year, there are mixed views about the outlook for fixed interest. Some fund managers and commentators believe the current European economic environment of low stable growth provides a favourable backdrop for bonds while others argue that bonds are unattractive because of their low yields.

Lower real yields

In the euroland area, 10-year government bonds are currently yielding an average of 3.88 per cent. But Charles Dumas, economist at Lombard Street Research, says he expects lower real yields next year because of “the rise in private savings rates and demograph�ically driven fall in investment rates. Lower inflation is also plausible if the world economy slows and the euro rises, although recent experience must make one wary of this scenario.” A fall in yields will, of course, push government bond prices still higher.

But of all developed economies, Mr Dumas says the least favourable outlook for government bonds is in the UK. “In the case of the UK, the strong economic and monetary expansion, and probable further declines in the currency, is reason enough to downplay global deflationary influences.”

While commentators such as Mr Dumas believe government bond yields in Europe could fall further, others say the reward of holding European corpor�ate bonds in terms of the available spread over government bonds is not sufficient to compensate for the extra risk. The Merrill Lynch European Corpor�ate Bond index, for example, now trades about 30 basis points over swaps. It is argued that in a world of heightened uncertainty, not least about the pace of global economic growth next year, corporate bond spreads priced at the tight end of the historical range does not make them an appealing asset class.

It is also argued that investors might want to move slightly along the yield curve while maintaining a bias to short-dated bonds. The yield curve is steeper in Continental Europe than in the UK. If yields stay the same, investors can benefit from an average two-year yield at 2.60 per cent compar�ed with a 2.30 per cent one-year yield.

Pierre Vanhove, manager of the Fortis L Bond Euro C fund, agrees with the negative view of corporate bonds. The fund has no exposure to corporate bonds and only 6 per cent of its assets are invested in collateralised bonds.

“Corporate bonds have done well this year but we believe spreads with government bonds at 0.45 per cent are too tight in the current environment,” says Mr Vanhove. “Spreads at this level are not worth the extra risk. We believe there will be a slower earnings momen�tum and some negative corporate news. The tight spreads will widen if com�panies report disappointing earnings.”

Mr Vanhove adds that in the medium term, he is still optimistic about government bonds in Europe. He believes that government bond yields can fall still further and therefore investors can make capital gains. This is despite the fact that 10-year government bonds are only yielding 3.88 per cent and 30-year bond yields are between 0.20 and 0.30 per cent higher. This belief is based on Mr Vanhove’s cautious view on the outlook for economic growth in Continental Europe.

Worrying signs

In the second quarter, output in the euroland grew by 0.5 per cent, which was down from 0.7 per cent in the first quarter. Worryingly, there are signs that domestic demand remained weak in the third quarter. The annual change in car sales was down 0.7 per cent in September, with declines in Germany, France, Italy, the Netherlands and Finland. For the euroland as a whole, car sales fell 7.6 per cent in the second quarter. The consensus predicts economic growth for the eurozone of 1.8 per cent for 2004, while the average unemployment rate in the eurozone remains high at around 9 per cent.

Rajeev de Mello, manager of the Pictet FIF-Eur Bds-P Cap fund, believes government bond yields will be in a trading range of 3.90 to 4.4 per cent in the immediate future. “We continue to believe the ECB will leave interest rates unchanged for a while yet even though inflation is pitched slightly above its official target rate.

“In this unsettled climate marked by geopolit�ical and macroeconomic uncertainties, if the statistics for the eurozone continue to display contrast�ing readings, bond yields could quite conceivably hover around current levels for a while.”

Alexander Mertz, manager of the UniEuroKapital Corporates A fund, has a neutral view on investment grade cor�porate bonds. “In aggregate, corporate bond spreads are about 0.50 per cent above government bonds. But the fundamental economic environment for companies in Europe is improving.

“Over the past two years, managers of companies have started to focus on providing value to bond holders as well as shareholders. Cash flow has also improved at European companies and therefore the risk of default of corporate bonds has come down. We believe default rates will remain low over the next two years and do not expect spreads over government bonds to widen. We think the European economy can fulfil its growth expectations.”

Still strong

John de Garis, manager of the Credit Suisse BF (Lux) Euro B fund, is overweight in corporate bonds. He says: “There are a number of factors that support credit. The macro economic environment is still relatively strong. Even with the expected economic slow down in the US, we still believe the situation in Europe is quite positive. The amount of leverage of European companies has come down as has the default rates.”

Gary Potter, co-fund manager of the Credit Suisse Portfolio Service, who admits the recent bond rally caught “most people out”, believes investors should now choose fund managers who have the flexibility to switch between government and corporate bonds and different grades of credit. “The most successful managers will be those who take a pragmatic approach in this environment. We expect slow economic growth next year and do not think interest rates will rise much further.”

‘The European economy can fulfil its growth expectations’
Alexander Mertz, Union