More than the sum of its parts

The major bond fund managers are rapidly expanding their choice of global and regional funds. A whole host of euro-denominated funds has already emerged and 'euro pricing' is now being offered on a numberof existing funds.
The short-term prospects for bonds are likely to be dictated by the extent of the slowdown in global growth and the prospect of a move from disinflation to deflation as this year progresses. In terms of euro returns, the change from sovereign risk to credit risk is an issue. The focus will be on managing credit risk and duration. The birth of the euro has virtually overnight created a rival to the US in the government bond market. Figures show that the euro government market is around $4.4trn (E6trn). By contrast the US Treasury market is approximately $3.7trn. Robert Begbie, director of treasury at Royal Bank of Scotland International, believes that if the euro does cement Europe's fragmented capital markets, many central banks and private in-vestors are likely to rebalance their as-set allocation much more towards euro assets: For bond investors seeking a large liquid alternative to the US treasury market, the sum of the eurobond market is, in effect, much larger than its parts. Any major shift by Japanese and other foreign investors from US treasuries to euro government bonds would put pressure on the value of the US dollar against the euro."
Should investors be worrying about whether a Belgian bond is better than a German bond, both euro-denominated? To a large extent, this depends on the profile of the investor. At the moment, a Belgian bond is giving 20 basis points more than a German bond, but it's a less liquid market, so then it becomes a question of how much you value liquidity and how long term a view you can take. The yield spread on Belgian bonds is quite wide at the moment because of the flight to quality over Brazil. But that is a short-term phenomenon.
Having said all that, there is not much difference between a Belgian or German bond, the question arises more in assessing a Belgian bond against a high yield corporate bond.
The main issue, according to Merrill Lynch's chief fixed income strategist Cesar Molinas, is diversification. Investment restrictions are being lifted and a pension fund, forced to invest 80% in assets that match the currency of the liabilities, now has a single currency. The changes this is bringing about are a diversification down the credit curve and into different non-euro currencies. The development of high yield corporate bonds, hedge funds and private equity funds may be fuelled by the increasing demand for higher yields in the expected low inflation environment over the near term.
For risk management, the goalposts have been moved and Europe's institutions, starved of returns to match their funding needs, must guard against a lack of proper analysis as the number of new issues grows. Of course, this creates an opportunity for the growth of credit analysis.
Overall, while the euro bond market is already showing signs that it will work very well, it may become tough-er for managers to beat the benchmarks. Indexing is not a satisfactory solution, says Molinas, because investors will need to find extra yields.
Daniel Knuchel, head of fixed income at Credit Suisse in Zurich agrees that it will be increasingly difficult for fund managers to beat the benchmarks using only euro-zone bonds: "Now that the advantages of diversification by countries has all but disappeared, the alternatives are the UK or maybe Scandinavia, but there is not a lot to go on there. Another option is to go for the countries who are set to join the EU: the more advanced east European countries. "But what is much more realistic is that bond credits will be the alternative. In the US, they have developed sophisticated sector categories, and I am confident that these will eventually be developed in Europe. "To begin with, the institutions will have to be careful, because they probably don't know too much, but certainly the demand for such productswill be there and credit diversification is the future," he says. Credit Suisse is building a team and hiring managers to handle this business: "We are ready to run credit portfolios and as far as I am aware a lot of investment houses are preparingfor it." Knuchel says: "The supply side is some way behind but I am optimistic that it will develop.""

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