April 2013

EUROPEAN BONDS: Not heading for the exit – yet

Ferris wheelThe idea that a great rotation is taking place from fixed income into equities is simplistic, European bond managers tell Fiona Rintoul. But it is clear they have been thinking hard about it. If the much discussed great rotation out of bonds and into equities ever takes place, European bond funds might be expected to take a tidy knock. Analysing the European debt markets is getting more and more like looking into a kaleidoscope. And, as the bailout crisis in Cyprus shows, the muffling of one European problem (Greek debt) can easily lead to another (failing Cypriot banks). Add to that low sovereign yields in countries that are not in a big mess and falling yields on European high yield debt, it is easy to see why investors might be heading for the exit. Yet they are not. In fact, the term great rotation is starting to sound tired. That it is bandied about with such abandon seems to have more to do with wishful thinking than fund flows. “Equity flows have improved, but there’s been no fall-off in European bond flows,” says Michael Krautzberger, head of the euro fixed income team at BlackRock. “We perhaps haven’t seen record inflows, but we’ve seen very decent inflows.” Any imminent rotating is more likely to have a starting point of cash than fixed income, suggests Mark Wauton, head of credit at Aviva Investors. “I don’t think we’ll see a major shift from credit into equities. What we will see is investors with cash or near cash moving into equities.” It is, nonetheless, true that the outlook for European bonds, particularly higher yield bonds, has deteriorated. Data from S&P Capital IQ show, for example, that the average yield on European non-investment grade bonds fell to 6% in January 2013 compared with 11% in early 2012, and that the probability of default is on the rise in Europe’s high yield universe. “There is a lot of nervousness about the corporate bond market,” says Bill Street, head of investments Europe, Middle East and Africa at State Street Global Advisors. “Although spreads are not as tight as they have been, absolute yields are low.” So, why are investors sticking with bonds – especially European bonds? There is a bit of push and a bit of pull. If you simply do not want to take on equity risk, there are not a lot of places to go other than fixed income. “People complain about low yields, but what is the alternative?” asks Tanguy Le Saout, head of European fixed income at Pioneer Investments. “The banks are full of cash yielding nothing.” Not that this means it is the right time to buy equities. “If equity markets have recovered from their lows, why is now, in particular, the best opportunity to pile in?” he asks. “For them to go significantly higher at current levels, we need growth and, in Europe, it’s not as clear as we might imagine where that growth will come from.” Most investors were caught offside by the recent equity rally and did not add enough risk, he adds. They are now wary of compounding this error by adding risk at the wrong time. SEGMENTATION
Of course, where you stand on this depends very much on where you sit – and country differences in Europe have intensified during the euro crisis. “There is segmentation between countries,” says Nicholas Forest, global head of fixed income at Dexia Asset Management. “Maybe for German investors, it makes sense to buy German equities rather than German bonds, but it’s different for Spanish investors.” Different types of investors will assess the situation differently. Among pension funds, for example, Wauton sees a continued move over time away from equities and into fixed income, because client sponsors think more about risk-adjusted returns. “Given the underfunded nature of a lot of pension funds, rather than go into broader equities, they are moving out of pure sovereigns or cash into the higher yielding component of the fixed income market.” Le Saout also observes a move up the risk curve within fixed income. “As long as interest rates are kept low, risk premia compress and little by little this pushes investors into riskier assets,” he says. In Europe, this trajectory may eventually lead to investments with a quasi-equity component. “People are looking to see where they can take risks,” says Wauton. “The hybrid market comes under the credit banner, but with an equity component.” Pushing the fixed income boundaries may be as far as many investors are prepared to go for now. The faith in equities that a great rotation would require doesn’t seem to be there. “With cash rates hovering around zero, there has been a stretch for yield,” says Street. “But investors are twitchy. Confidence is very shaky. It’s been a very unconfident rally.” It has also been a rally fuelled by central bank liquidity. Now people want to see some hard numbers, for example, falling unemployment, to back that up. “If we don’t see fundamental growth coming through, the market will lose patience,” says Street. “Having seen a rally in the US and Europe, the market needs good fundamental support. Investors want to see the steroidal liquidity that we’ve had making a difference.”   For their part, bond fund managers believe the environment continues to favour fixed income assets. Forest cites, in particular, low growth and continuing high budget deficits in developed markets. “In this context, we need low rates to finance the deficit. This cycle will remain supportive for bonds,” he says. He also points out that bond and equity returns have both been positive. “It’s not sustainable. I expect a normalisation of this correlation. Maybe there will be a slowdown of the equity rally.” And even if some solid economic growth numbers do come through, bond fund managers do not necessarily expect what Forest terms “a bond bloodbath”. But, says Wauton: “If we get confirmed evidence that the US is barrelling along and China has above trend growth, then equities could start to look attractive. Even then, many investors won’t come out of credit. What will suffer is government bonds.” Against this background, what are the arguments for investing in European bonds specifically? Some European institutional investors will have rules that more or less force them into the asset class. But BlackRock reports a large recent inflow to the asset class out of Asia. A driver of such inflows is that, while European bond yields may not be earth-shatteringly high, over the piece they are not that bad. “Yields are significantly better in Europe than in the US and Japan,” says Krautzberger. “If you calculate across all countries the five-year forward rate is 4%.” A 4% rate for the European economy, which is expected to grow at below 2% with inflation below 2%, is quite all right, thank you. And for a European bond fund manager the continent’s weakness – the euro crisis and the segmentation it has caused – is also an important strength. “From an active management perspective, the environment is much better than 2007,” says Krautzberger. “There is so much volatility and opportunity, partly driven by political events. We see a lot of relative value movements. There’s much more to gain now from good analysis.” RE-RISKING
Clients, it seems, want to embrace these opportunities, born to some extent out of chaos. “More investors want to leave the traditional benchmark approach behind,” says Forest. “A lot of investors want to diversify the benchmark.” “Re-risking is needed,” says Street. “People want to re-risk; to have a great rotation, but we have not not seen it yet.” The main factors that will determine if and when re-risking happens are economic fundamentals and central banks’ exit strategies from quantitative easing. Here, the eurozone is ahead of the game. “The European Central Bank exit strategy is built into what it has done,” says Le Saout. At the same time, the risk of another shock in Europe can scarcely be ruled out. As always, the elusive variable of confidence is all-important. “If we can get industrial confidence or man-on-the-street confidence, then the great rotation could have legs,” says Street. Right now, that confidence is simply missing. ©2013 funds europe

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