Biggest Bond Buyers Favor European Notes as ECB Cut

The world’s biggest bond investors are betting European Central Bank President Jean-Claude Trichet will be forced to follow Federal Reserve Chairman Ben S. Bernanke and step up the pace of interest-rate cuts.

BlackRock Inc., Schroder Investment Management and Standard Life Investments Ltd., which together oversee $1.6 trillion, are buying German debt securities even though yields are close to record lows. Barclays Capital, the top primary dealer of German debt, says bunds offer “unprecedented value” because the ECB will accelerate rate cuts as the economic slump deepens.

“It still makes sense to be long selective markets and Europe is one of those,” said Michael Krautzberger, a European fund manager in London at BlackRock, which manages $1.3 trillion. “The ECB is behind the curve.”

While the Fed reduced its target rate 4.25 percentage points this year to as low as zero, and the Bank of England cut its benchmark by 3.5 percentage points to 2 percent, the Frankfurt- based ECB lagged behind.

The ECB lowered the main refinancing rate by 1.5 percentage points to 2.5 percent and will cut the benchmark rate 1 percentage point to 1.5 percent by June, based on the median of 16 economists’ forecasts compiled by Bloomberg.

Closer to Fed

Even though Trichet said in a Dec. 16 speech further reductions may fail to bolster the economy as long as banks refuse to lend to each other, the ECB may bring its key rate closer to the Fed’s, according to Gregor MacIntosh, a money manager in Edinburgh at Standard Life. The firm has about $265 billion in assets.

“The European economy will underperform the U.S. next year,” Macintosh said. “On a relative basis, European bonds look more attractive than the U.S. market.”

German bunds returned 12.1 percent this year, including price gains and reinvested interest, the most since gaining 16 percent in 1995, according to Merrill Lynch & Co. index data. French government debt returned 11.5 percent, while Spanish bonds added 8.8 percent.

Treasuries returned more than bunds, handing investors 14.6 percent. A rally in Treasuries in the fourth quarter pushed 10- year U.S. debt yields to 89 basis points below bunds of similar maturity, the lowest since 1993. As recently as last month they yielded 22 basis points, or 0.22 percentage point, more than bunds.

The spread was 84 basis points by 3:29 p.m. in London.

‘Unlikely’ Reversal

Investors piled into the relative safety of government debt this year as credit losses and writedowns at the world’s largest financial companies surpassed $1 trillion and Europe, the U.S. and Japan entered their first simultaneous recessions since World War II. The rally drove yields on German two-year notes down by more than 200 basis points to 1.73 percent, the steepest drop since falling 268 basis points in 1995.

“A reversal of the bullish trend is unlikely to take hold before the third quarter of next year,” said Laurent Fransolet, head of European fixed-income strategy at Barclays in London. Fransolet recommends bonds due in five and 10 years, which he says offer “unprecedented value.”

Yields on German 10-year notes will fall to 2.85 percent by the end of the second quarter from 2.93 percent last week before rising to 3.20 percent at year-end 2009, according to Barclays. The London-based bank buys more debt at German government-bonds auctions than any of the other 28 primary dealers, according to the Bundesbank.

Breaking Even

While analysts expect yields on 10-year bunds to rise to 3.4 percent by the end of 2009, investors will likely break even for the year, according to the median of 10 forecasts compiled by Bloomberg.

An investor buying $1 million of 10-year bunds would lose about $5,000 by the end of next year if the yield rose to the level forecast in the survey. That compares with the $78,000 a buyer of the same amount of 10-year Treasuries would lose should the yield increase to the 3.4 percent predicted in a separate Bloomberg poll of 54 strategists.

Bonds may fall in 2009 as governments prepare to sell a record amount of debt to finance bank bailouts amid falling tax revenue, according to Zurich-based UBS AG, Switzerland’s biggest bank.

Germany will issue a record 323 billion euros ($456 billion) of debt next year, including 149 billion euros of bonds maturing in more than one year, according to the Federal Finance Agency. France plans to sell a record 145 billion euros of securities.

‘Overwhelming Issuance’

“The sheer amount of issuance due from European governments is likely to overwhelm potential demand,” UBS strategists Meyrick Chapman and Andrew Rowan wrote in a report to clients Dec. 18. Investors will see “the bulk of the returns” in the first half and “barely break even” in the second, the London- based analysts said.

Two-year German note yields will rise to 2.05 percent by the end of next year, according to the median of 10 economists’ forecasts compiled by Bloomberg, from 1.694 percent today.

The global credit seizure prompted the world’s biggest central banks to cut rates and offer record amounts of cash to prevent financial institutions from collapse following the Sept. 15 bankruptcy of Lehman Brothers Holdings Inc.

“A quicker-than-expected return to risk appetite is a risk for bonds and could lead to a sell-off, even though the European economy isn’t likely to recover in the next half or one year from now,” said Michiel de Bruin, who manages about $18 billion as head of European government bonds at F&C Asset Management’s Dutch unit in Amsterdam.

No Choice on Rates

Trichet may have no choice but to lower borrowing costs again, according to David Scammell, a money manager in London at Schroder, a unit of the U.K.’s largest publicly traded fund company. The economy of the 15 nations sharing the euro will shrink 1 percent in 2009 after expanding 1 percent this year, based on the median of 15 forecasts compiled by Bloomberg. The U.S. is likely to contract 1 percent, a separate poll shows.

“Poor economic numbers will bring them to their knees,” said Scammell, whose parent firm oversees $19 billion of assets. “The ECB will have to cut interest rates more aggressively. We are bullish on European bonds, as next year is not going to be any better than this year in terms of the economy.”

Growing pessimism over the economy and expectations of rate reductions drove the yield on two-year bonds to 148 basis points below 10-year bunds in November, the widest spread since 2004.

As the ECB brings rates closer to zero, the gap may narrow because investors will seek higher yields offered by longer-dated securities, Scammell said.

“The curve will flatten because there’s nowhere for the short end to go anymore, and not because of expectations of an economic recovery,” he said. “The U.S. led this cycle and it’s moving into a curve-flattening mode. Europe is likely to follow.”