Play the spreads before the euro comes

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The Independent Online
Helena Morrissey, (HM) director at Newton Investment Asset Management, talks to Kerrin Howard (KH) about the outlook for UK, German and Greek bond markets.

KH: What is your three-month outlook for 10-year bond yields in Europe, especially Germany and the UK?

HM: We like both markets. I believe German 10-year yields will stay low - below 5 per cent - and that UK yields will creep down towards that level. The spread will narrow. I don't see any inflationary upsets or concerns about growth rocking bond markets in the period.

KH: Why will UK bond yields fall?

HM: There are a number of factors: speculation over the UK joining EMU will help narrow the spread over the next few months, and economic data is starting to show some weakening of activity. The fact the Bank of England's monetary committee is split on interest rates and keeping the market on tenterhooks is holding the long end of the gilt curve back because the funding costs are high. But over the next three months people will start to look forward to the next move in rates being down, and that will contribute to more spread narrowing.

KH: When will that rate cut come?

HM: The market gets ahead of itself and starts to pre-empt change. If the Bank of England does move rates up, which you cannot discount entirely given their hawkishness, then immediately the market will start to look for a cut. Investors will take the view that the combination of tight monetary policy and tighter fiscal policy this year than last, combined with strong sterling, means that the implications for growth will be very negative in the UK. Then they will factor in a rate cut by the end of the year, if not sooner. Spotting the timing is always difficult but it is really the direction which is important.

KH: How did the market react to the Budget?

HM: The Budget was a non-event for the gilt market, trading aggressively on it for just one day. There is going to be net repayment of debt in the next 12 months, a bullish backdrop for gilts because there will be a shortage for long-term investors like us.

KH: Do you think we will have a lot of non-government issuance in sterling the next year?

HM: A lot of people have expected a flood at some stage. There will be ongoing supply, like in the US debt market, which will mitigate the lack of supply of new government debt. But many investors are still very conservative on what they will buy and stick to investment grade or government debt. So more sterling bonds won't take away the bullish backdrop for gilts and crowd out the buyers. I expect a trickle of non-government issues rather than an avalanche, much as we have seen in the first quarter.

KH: In fact, we are at record levels for eurosterling issues.

HM: Yes, and that will continue but it won't be a great boom. The changes to ACT mean that investors are having to look for higher yields than they are getting in gilts and that will create interest in non-government bonds. Also for actuarial reasons people now want to buy more bonds. It's a question of supply and demand, and that points to increased amounts of eurosterling issuance than before.

KH: What about Germany? Are we going to see higher rates there?

HM: I expect unchanged rates in Germany for a while. People got very excited when Finland raised rates and looked for higher German rates to follow. You can't rule out surprises, but I think the last thing the German economy needs is higher rates. Other European economies don't want quite such low rates as in Germany, but I don't see the Bundesbank moving over the next couple of months.

KH: You are holding Greek bonds just as Greece is joining the ERM. Were you invested before that move?

HM: Luckily we were invested before and had a currency hedge. Although it looked clever on the day, we had taken some pain in the months beforehand. We added to our position in the 10- and 7-year Greek bonds after the move. A lot of people think Greece is a basket case like Italy was, and did not want to have anything to do with it. But it has not paid to be a eurosceptic in recent years, and I still think it will continue not to pay. You have to assume the Greek government will continue to muddle through, doing the right things and looking to Italy as a role model. It might look odd for Greek debt to yield 8 per cent rather than 10 per cent, but it's the only game in town for anyone wanting to play spreads within ERM members. It was a neat move for Greece to accomplish a devaluation of the currency and win the credibility of the Bundesbank in one fell swoop.

KH: You have a high-yield fund. Is this market is going to grow?

HM: I think over coming years the euro-denominated debt markets will look more and more like the US fixed-income market. There will be more specialist sectors such as mortgage backed, asset backed and corporate, and more investment-grade securities. There are a number of factors here: currency is less important because of the arrival of the single currency, and French and German debt has yielded the same for some time now, for instance. On the demand side, the appetite is growing. Many funds still have investment-grade restrictions in the portfolios but will become more comfortable with high-yield securities over the next few years. This will benefit companies who have hitherto had to rely on banks for their borrowing and can now come to the market. In a few years, pension funds in Europe will be trading the spreads just as they do in dollar-denominated debt.

KH: What percentage of your fund is in high-yield bonds?

HM: Relatively low - just 1 or 2 per cent. We will be talking to trustees about whether they are ready to relax guidelines for future reference.

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