This combination has led to strong returns from the UK and US fixed interest markets in recent years, but with monetary policy expected to tighten as the economic recovery takes hold, investors are becoming increasingly wary. The AXA and Fidelity managers point to Europe as a market that can fill the void. The European Central Bank (ECB) recently signalled interest rates would stay low until at least the end of 2016 whilst its president Mario Draghi hinted at further liquidity measures to stimulate the stagnant economy.
The ECB cut interest rates to near zero earlier this month and lowered deposit rates to negative, effectively charging banks to stash money rather than lending it out to businesses and consumers.
Chris Iggo, fixed income chief investment officer at AXA Investment Managers, says European fixed income is likely to remain attractive in the medium-term as a result, particularly in comparison to government debt in the US and UK.
He explained: “We welcome the recent policy initiatives by the ECB and the strong signal that policy rates should stay close to zero for a very long time.”
“This supports further good performance by southern European government bonds as well as European bank debt and more equity like products such as subordinated corporate debt issued by, for example, utility companies.”
European government and corporate bonds have recovered from the troubles of 2011, when there were genuine fears that the eurozone could break up. The asset class rebounded strongly for much in 2012, but has been broadly flat over the past 18 months or so.
Peripheral Europe has continued delivering strong returns, however.
Performance of fund and indices since Jan 2011
Source: FE Analytics
“Spanish and Italian government bonds could soon be trading within 100 basis points of German debt,” he said “This is only two years since the ECB promised to save the euro.”
“It appears to have served fixed income investors very well. For Europe, at least, the fixed income party should continue.”
Iggo says his bullish stance on European fixed income will be complimented by a move away from government bonds which are most at risk from increased interest rate risk, particularly in the US and the UK.
Andrew Wells, fixed income global chief investment officer at Fidelity, is more wary than Iggo, but thinks that the likelihood of quantitative easing makes European fixed interest a strong contender for a portfolio.
“There are lots of investors looking for income-based solutions, moving along the curve and into credit markets. These investors are switching out of high-volatility equity and also out of cash and money market funds that produce limited return,” he explained.
“The region may not seem like the right place to invest as a fixed income investor given low rates, but as we’ve previously seen in Japan and the US, when there is QE you want to be in the bond market.”
“They are seeing a deluge of negative headlines about unemployment, stagnation and low inflation. But considering the 8 per cent return in European high yield in 2013, which made it the best-performing asset class in fixed income, I think we’ll continue to see solid returns from European bonds.”
Performance of European high yield bond funds in 2013
Source: FE Analytics
The Invesco Perpetual European High Income fund does have a sizeable exposure to equities, currently at 33 per cent, which helped the fund outperform so strongly over the 12 month period.
Mark Burgess (pictured), chief investment officer at Threadneedle, says the outlook for eurozone bond markets is hard to call due to the sluggish outlook for economic growth. “Certainly Germany and Spain appear to have positive growth momentum, which should put some upward pressure on yields if that momentum remains,” he said.
“By contrast, the growth outlook in countries such as Italy and France remains very subdued, which is likely to keep yields low.”
“The lack of growth in France and Italy is worrying given that debt levels remain elevated at a time when inflation in the eurozone overall is very low, just 0.5 per cent for the year ending May 2014.”
He adds that the new loosening of monetary policy, including a new programme of long term refinancing operations (LTROs) to aid bank lending, will not necessarily work as well as it did in the UK and US.
“Whether this policy response will work remains to be seen, but it shows that the ECB is definitely not resigned to a protracted period of low inflation,” he said.
