It has hardly been the most unpredictable first few months for the European bond markets in 2003. Economic situation – gloomy, war in Iraq – probable, ECB rate cuts – likely. An environment, which although has been positive for the European bond market, driving a sharp downward spike in yields, has also been a little bit dull, …until up jumped the Bank of England (BoE) with a 25 basis point rate cut to 3.75%!
Considered as the sturdiest of the European economies, with escalating property prices and inflationary risks, it is fair to say that such a move in the UK caught 99% of market participants by surprise. The gilt market certainly now looks overpriced, but who can be sure that there won’t be another rate cut in the UK? Sylvain de Ruijter, head of OECD fixed income at ING Investment Management in The Hague says: “On fundamentals, we would expect UK yields to rise somewhat versus European yields, so a widening of a 10-year spread differential. Currently, UK yields are about 20bp above Euroland yields. But now nobody knows. The BoE may cut again.”
Emma du Haney, client portfolio manager at Credit Suisse Asset Management in London agrees that Gilt yields are unlikely to go lower.
In Euroland, little has changed since February. A gloomy economic outlook and falling inflation indicates that monetary easing by the European Central Bank is inevitable. At the short-end, a quarter point rate cut has already been anticipated, and short-dated yields are approaching lows from the previous cycle. That said, there is still some value to be had if the more likely 50bp cut is coming, believes de Ruijter.
At the longer end, yield direction is harder to predict. With little value at the short end, investors will start the move out along the yield curve, says du Haney. “The 10-year Bund could go down as far as 3.9%, and with two-year yields not expected to fall lower than 2.4%, we could well see a flattening of the yield curve over the coming months.” Emanuele Ravano, executive vice president and head of portfolio management at PIMCO in London, agrees, that although the long-end of the curve is slightly steeper than in the last cycle, the five- to 10-year area could flatten.
If the situation in Iraq is prolonged and worsens, long-end yields will surely go down as investors make the flight to quality away from equity markets, agrees de Ruijter. But the market is not expecting it to happen – oil prices are not a crisis level – so 10-year yields could then rise, albeit less so in Europe than in the US, he says.
Vincent Cornet, global head of fixed income of Axa Investment Managers in Paris, foresees a turbulent few weeks on the horizon, but is expecting long-end yields to go up after, what he terms as “the choppy period” is over. Axa IM’s predictions see 10-year Treasuries at 4.25%, 10-year Bunds at 4.3%, 10-year Japanese government bond yields at 1%, and 10-year gilts at 4.6%.
In the corporate bond market, fund managers are remaining cautious in the short-run. Du Haney and Ravano both recommend a neutral weighting – company deleveraging and an economic turn around will be positive for the asset class in the long term, but if equities continue to be weak then corporate bonds could be vulnerable. For now investors prefer the short-end. Says Ravano: “Liquidity provisions are quite high and therefore corporate bond positions two-years and in are reasonably well-covered, but even here we stress diversification.” Du Haney advocates holding single A and triple B names in Euroland over triple A and double A swap related paper. However, name selection clearly remains crucial. Ravano, on the other hand is looking at telecoms in Europe, citing France Telecom’s rare 30-year deal as offering value at over 8% yield. Indeed, when it comes to the corporate bond market, diversification and selection seem to be key. Cornet admits to being more selective than ever. “We are in the worst period ever of visibility. Risk management and research is key. It always has been, but now, in the current climate, it is more important than ever. It is not a time for taking big bets.”