Sceptics still see value in German bonds

Financial News

January 4, 2004

It takes courage to be optimistic about the outlook for bond prices in 2004 - especially after a run-up of 100 basis points for the 10-year German government bond since yields hit a multi-year low last June.This is particularly true since all leading indicators point to a weak, export-led recovery in Germany this year.

If the powerful upsurge in US growth proves more than a flash in the pan, then it may be time for global investors to exchange bonds for equities. However, there is no shortage of sceptics who see value in German bonds in 2004.

Christian Walburg, an economist at the German Association of Mortgage Banks, whose members issue Pfandbrief-covered bonds, said: "We are relatively optimistic, at least for the first half of 2004. We expect high demand for the product to continue next year. Although we don't forecast interest rates, my gut feeling is that things are not so bad."

Claus Meyer-Cording, director of bonds at DWS, the mutual fund arm of Deutsche Bank, said the spreading fear of rising interest rates will not stop his organisation buying bonds.

He said: "The official interest-tightening is priced in and would not surprise the market. In a normal scenario the US Federal Reserve would act. But we think that the Fed won't be as aggressive as some have feared."

Walburg and Meyer-Cording anticipate an improvement in credit ratings for some issuers. Meyer-Cording, citing the yield advantage over Bunds of debt issued by the Italian government and KfW, the German government financing agency, said: "We would buy where the spread is best. Pfandbrief spreads are narrow. I don't think they will widen much."

Thomas Hueck, director of economics for Munich's HVB, said even if the Federal Reserve embarks on a new rising rate cycle, there is still something to be said for higher-yielding corporate debt, which remains a tiny segment of the German market.

He said: "The spreads for corporate bonds should tighten. Stocks are up and the prospect of strong profit for the next quarter is driving the market in the corporate sector. This is a good environment for equities, poor for sovereign debt. The Fed will tighten. There would then be a flattening of the yield curve from a rise in short-term interest rates."

Christian Schiweck, a bond fund manager at Deka Bank, agreed that 2004 will be a bad year for short and middle maturities because of rising central bank rates. As far as corporate bonds are concerned, he said: "The spreads are already tight and no big change is expected. High demand continues because people earn the yield advantage.

"This demand will grow. There are many redemptions, for example Deutsche Telekom's debt reduction. It's possible that demand will exceed supply."

Georg Huber, director of corporate bond origination and asset securitisation for Bayerische Landesbank, said he was looking for a slight improvement for corporates for much the same reasons. "We see a trend of growth. The product is tapping into new groups of customers."

While prevailing opinion at the Frankfurt interest-rate forum envisaged an end to the bull market for bonds this year, sharply rising interest rates and crashing bond prices were not expected.

Strategists at Dresdner Kleinwort Wasserstein are even predicting 10-year yields of 3.6% for US treasuries and 3.8% for the German government equivalent by the end of 2004, significantly down on year-end yields.

In contrast, the consensus of other rate-watchers is that yields will hit at least 5% by the end of this year.

Kornelius Purps, who analyses sovereign debt for HVB, said: "Rates can only go up." He cited the US mismatch between the 8% third-quarter GDP growth spurt, the 2% inflation rate and the Fed's 1% call rate.

"This means a negative 1% real interest rate at a time when the economy is growing strongly. That can't be," he added.

Yet bond market bulls such as DrKW draw optimism not from rate analysis but from doubts about the source and durability of the US economic recovery.

Hueck said: "The reason for the recent 8% jump in US GDP was the tax rebate last July and August. And the reason for that is the presidential election campaign. This isn't such a bad thing.

But we doubt whether the accelerator or multiplier effect will last to the end of the year. Therefore, the US economy will lose momentum in the second half of 2004. The reason is that the upswing has been driven by fiscal and monetary policy."

He said demand outside the US remained weak. The European economy depends on exports, the Japanese recovery is modest and booming China pegs its currency to dollars. He sees no pent-up demand in the US economy, where capacity use is at historic lows despite three years of declining business investment, the public sector is spawning deficits and the private sector has not been able to whittle down its debt.

Hueck sees 2004 as a year of two halves in the bond market. He said: "The market has reacted to quite strong movement of the global economy.

"For the next six months we see rising yields and a decline in bonds, namely 5.5% for 10-year US treasuries and perhaps 5.25% for German Bunds.

"But I do not see a long-term upswing. So, yields will be lower by the end of this year, namely 4.75% for 10-year US treasuries and 25 basis points to 40bp lower than that in Germany."

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