Sovereign crisis ‘masks opportunities in European credit’

After the bailouts of Greece and Ireland in 2010, sovereign debt risk in Europe is set to remain a key story for 2011 according to Fatima Luis and Rebecca Seabrook, who co-manage the F&C Strategic Bond Fund.

However, they say this should become less of an issue as the year progresses, and that perhaps Europe is not in such a precarious position as the market fears.

With prospects for sovereign debt still uncertain, however, investors might welcome a fund that has free rein to invest in any area of the credit market. The F&C Strategic Bond Fund is one of a handful of corporate bond funds that has a brief to roam across the entire credit spectrum - from investment grade to ‘high yield' - depending on where the best opportunities arise. Launched in February 2000, it was one of the first funds of its kind, and has been managed by Luis since inception.

Luis commented: "2010 has actually been a good year in terms of corporate credit markets, but events in Europe these last few months have exacerbated market volatility and illiquidity has returned once more. Although concerns about the balance sheets of some of the Eurozone member states will undoubtedly dominate headlines for the near future, we nonetheless believe that the market will likely begin to adopt a longer-term outlook and a more rational perspective."

Troubled Europe ‘could surprise market'

Seabrook and Luis acknowledge that the ultimate solutions to the debt crisis will be determined by factors outside investors' control while the European Union and the International Monetary Fund fight to bring the situation under control. Both managers anticipate that it will take some time to identify a mutually effective resolution, and that fiscal convergence within the EU will be critical to its survival.

"Europe may not survive in its current guise; however, we don't envisage the demise of the Euro as some commentators have predicted," said Seabrook. "We may see a situation whereby the European Central Bank and stronger EU nations have some influence on how the weaker entities finance themselves. Regardless, we believe the events of this year will force the EU to introduce tighter controls and greater convergence of fiscal policies."

Luis and Seabrook also anticipate that Europe could surprise the markets in 2011, due to the significant divergence in outlook between the economies of its member states, pointing out that parts of Europe are performing very strongly and benefiting from the weaker currency, particularly Germany.

Luis explained: "Europe, especially Germany, is actually in better shape than it is perceived to be because the negative headlines are drowning out any positive news. Additionally, the real issues are centred on Government debt and the market is overlooking the fact that corporate Europe is in relatively good health. In fact interest rates could potentially go up sooner than everyone is expecting."

UK and US not out of the woods yet

While the bond market awaits a clearer picture on the effectiveness of quantitative easing in the UK, concerns persist of potential contagion from Europe crossing the Channel. Luis and Seabrook believe that the strong pound is providing some protection and, having already effectively resolved its own banking crisis two years ago, the UK is less exposed to sovereign debt fears than some of its Eurozone neighbours. Furthermore, a reasonable number of the ‘distressed' credit issues have been refinanced during 2010, so some of the pain has already been taken. The managers anticipate that these factors combined will give the market a little more confidence in the UK's stability going in to 2011.

Turning to the US, Seabrook believes that a second round of quantitative easing - "QE2" - is unlikely to reignite growth in the economy. "Asset price inflation, which would be a potential by-product of QE2, would be a welcome outcome for the debt-laden US consumer and Government," she commented. "However, we believe rate rises are unlikely, since the combination of low growth, high unemployment and high debt means the US authorities will almost certainly shy away from introducing higher rates for a prolonged period of time. A further by-product of this policy is likely to be steeper yield curves, making us more cautious on the treasury market and longer-dated bonds."

Regulation raises spectre of ‘haircuts' on bank debt

On a cautionary note, Seabrook warns that changes to bank regulation could have a massive impact on bond holders in 2011.

"Regulation to date has generally been bond-positive, however there is huge uncertainty over the future shape of bank capital. ‘Bail-in' clauses on senior bonds - where senior bonds are rendered partially loss-bearing in a distressed situation - have the potential to upset the market dramatically if they are applied retrospectively to all outstanding bonds. There has been huge clarity so far in terms of Basel III, but there nonetheless remains a long way to go to clarify how banks will be financed from here and the role bond holders will play in that process," Seabrook explained.

Investors likely to favour high yield in a volatile market

Looking generally at 2011, Luis and Seabrook believe that high volatility will continue to be an issue, although they anticipate that credit quality will be maintained as long as companies continue to keep cash on the balance sheet.

Luis concluded: "Following the huge rally in credit over the last 2 years and the Federal Reserve's determination to reflate the US economy, investors may be tempted in this low rate, low default rate environment to move into riskier assets such as high yield and equities."