European bond markets are looking attractive once again now economic prospects are improving. Conver...
European bond markets are looking attractive once again now economic prospects are improving. Conversely in the US, which benefited from the flight to quality during the financial crisis of last year, prospects are dimming.
Stuart Steven, investment manager at Britannia Asset Management, says: "We have been overweight US and UK markets but we are reviewing our strategy. We are a little more relaxed about Europe on the currency view. The euro has stabilised and there are better prospects for the economy. The fact that the US may slow down argues in favour of Europe.
Steven thinks that for political reasons the European Central Bank would step in if any EU member government defaulted on a bond issue. Even so, he thinks the markets have not fully priced in this effect.
Market data suggests that the credit risk on European and US corporates, particularly financial institutions, is worsening. One key indicator of this is the swap spread. Swap spreads are the premium required by the market to exchange a fixed rate income from an institution, such as a bank, for a floating rate income.
Laurence Mutkin, head of fixed interest strategy and research at Threadneedle Investments, says: "Swap spreads in the US have widened out by 30 to 40 basis points since the beginning of the year but in Europe they have widened only by 15 to 20 basis points.
This might suggest that European banks have better credit quality than US banks but there are other factors involved, connected with thin trading levels over the summer and uncertainty on the direction of short-term interest rates.
There has been a lack of liquidity in the swap market, because no one wants long-dated swaps as there are fears interest rates will rise, says Steven. Unfortunately, this has coincided with the slower conditions of the summer, leaving players hoping the market will pick up again later in September.
He says: "Expectations of future interest rate rises are overdone at this point. Everybody wants to pay a fixed rate because interest rates are thought to be on the way up. In order to swap, you have to find someone who will take on a floating rate and no one wants to.
"Once we get some liquidity back in the market we will see a self-correction of this situation. It is a short-term not a long-term problem. The underlying quality of banks is improving. Bank balance sheets are getting stronger both in the UK and Europe. Swap spreads at the moment are not accurately reflecting the credit risk. It is purely a result of technical factors, not fundamentals.
"Yields have been held down artificially by the state guarantee which underpins German banks. The risk premium is lower in Germany than in UK but UK banks are stronger because they do not have the same emerging markets risks as German banks do, which are heavily invested in Latin America, Asia and Russia
He adds that there has been more issuance of bonds than gilts or Treasuries. Steven says: "The flight to quality has been met with more issuance by the Bundesbank, so there has been no liquidity squeeze." In fact, US swap spreads have finally begun to narrow. According to Mutkin, the week before last they were at about 112 basis points, but came in at 98 basis points on Tuesday last week.
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