Euro bonds: the best investments are not always the most obvious

The case for investing in Euro-denominated debt is not obvious at this time. Although yields have been rising since September 2005, they remain at relatively low levels.

And, if interest rates continue to rise, the chance of decent capital gains seems low. However, according to Paul Lavelle, Fixed Income Portfolio Manager at Fidelity International, further analysis can draw a different set of conclusions.

“Short-term concerns around the impact of interest rate policy on Euro bonds may well be overdone.” begins Mr Lavelle. “Central Bank rates in the Euro zone have been rising since November 2005, driven by a more favourable regional and global economic outlook, a rise in consumer consumption, and rising inflation. The key is whether future rate rises have been discounted by the market.

“The ECB has indicated that it will use rate policy to remain tough on inflation. Stronger domestic and global economic growth, higher wage settlements and asset inflation could give rise to higher consumer inflation which could, in turn, cause the ECB to increase rates further than expected. This, however, may be overly pessimistic: oil and other commodity prices have fallen, Chinese and emerging market demand has abated somewhat, European wage settlements have come in below expectations and tax rises coming into effect in 2007 could dampen growth, causing inflation to undershoot.

“Based on evidence from the US market, bond yields peak between 3 and 12 months before the first interest rate cut. If this pattern is repeated through the current European rate cycle, then investors waiting until rates actually start falling could miss significant positive capital returns from the European bond market. Bond markets could also get a major boost from investor rotation as investors seek to take profits in outperforming asset classes. European equity markets have performed extremely well since the low point in March 2003. Over the same period, bonds lagged. Even a moderate switch out of equities could have a major positive impact on European bond prices.

“At a micro level, Euro corporate bonds are also attractive. Company fundamentals remain very strong and there exist a wealth of investment opportunities to make the asset class attractive: Ongoing consolidation within the banking sector; continuing growth of structured products and asset-backed securities; a shakeout in the European telecoms sector and Emerging Europe - both through its inherent growth and its businesses being bought by Western European companies.

“The long-term case for investing in bonds remains very much in tact, concludes Mr Lavelle. “Many of the shorter-term market concerns over rising interest rates have already been priced in and, if history repeats itself, European bonds should start performing 3 to 12 months in advance of the first interest rate cuts. After a sustained period of strength in equity markets, there is also an argument for asset class rotation towards fixed income assets. If you add to this the large number of opportunities within the developed and emerging European bond markets, you have an asset class which has much to recommend it today. Attractive, yes; obvious, no. But the best investments are not always the most obvious ones!