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Bunds to Sustain Allure as Europe Hunts for Debt Crisis Cure: Euro Credit

Bunds will retain their haven allure as investors bet German approval of expanded powers for the euro area’s rescue fund will be no panacea for the debt crisis.

German government bonds, perceived to be among the safest debt securities, have handed investors the best quarterly return in more than two decades, exceeding those when Lehman Brothers Holdings Inc. (LEHMQ) filed the biggest bankruptcy in U.S. history. The gains pushed 10-year yields down to a record 1.636 percent on Sept. 23, prompting analysts to cut their fourth-quarter yield forecasts for the AAA rated securities.

“Bunds are extremely liquid and they are a safe haven,” said Alex Johnson, who helps oversee $47 billion as London-based head of portfolio management at Fischer Francis Trees & Watts. “It’s not obvious what the catalysts are going to be for a sustained sell-off.”

Bund yields have dropped after bailouts for Greece, Ireland and Portugal and following purchases of the most indebted nations’ bonds by the European Central Bank. Banks obliged to participate bought all the 5 billion euros ($6.7 billion) of notes Germany sold on Sept. 28 as other investors didn’t enter a single bid, according to six people with the knowledge of the sale.

Italy, Spain

While borrowing costs for Italy and Spain have declined from euro-era records with the ECB’s help, the two nations still must sell about 55 billion euros to 60 billion euros of bonds this year, underpinning demand for German debt, said David Schnautz, a fixed-income strategist at Commerzbank AG in London.

“Bunds will still be the place to be,” said Schnautz. “We have many hurdles to clear in terms of event risks, and we have supply coming from Italy and Spain.”

Commerzbank lowered its year-end forecast for 10-year German bond yields to 1.60 percent, from a previous prediction of 2.80 percent, Schnautz said on Sept. 30. The 10-year yield fell seven basis points to 1.82 percent at 2:25 p.m. in London, while two-year yields were six basis points lower at 0.49 percent.

Europe’s politicians are putting together a 159 billion- euro plan for Greece after a 110 billion-euro bailout package agreed in May last year failed to bring down that nation’s borrowing costs. Bunds fell last week as lawmakers approved giving a euro-region rescue fund the power to buy bonds in the secondary market, enable bank recapitalizations and offer precautionary credit lines.

Uncertainty Remains

Germany’s 10-year yields, which fell more than 110 basis points to 1.91 percent in the three months through Sept. 30, will probably end the year at 2.20 percent, according to a Bloomberg survey of economists that in August was predicting 2.65 percent for December. Yields may stay near 2 percent for the rest of 2011, said Karsten Linowsky, a fixed-income strategist at Credit Suisse Group AG in Zurich.

“We still have a lot of uncertainty and that will keep the yield at a low level,” said Linowsky. “It depends a bit on the political process, and October will be critical.”

Demand for the relative safety of bunds is likely to be supported as Europe’s economic outlook deteriorates. ECB President Jean-Claude Trichet said last month the economy faces “intensified downside risks” as the central bank cut its growth forecasts for this year and next.

Balance Budget

Global investors say a default by the Greek government is inevitable, with 93 percent predicting the nation will eventually fail to meet its debt commitments, a Bloomberg survey published last week found. Greek bonds have tumbled as Europe’s policy makers wrangle over the terms of the new bailout and as credit-default swaps signal the probability of non-payment is more than 90 percent.

German bonds returned 7.9 percent in the third quarter, the most since at least 1986, according to Bank of America Merrill Lynch indexes. Italian bonds made a 4.1 percent loss, even as the ECB bought the securities, while Spanish bonds handed investors a 2.5 percent return, the indexes show. Bunds have made 7.8 this year, set for the biggest rally since making 12 percent three years ago.

The slump in Italy’s bonds pushed the 10-year yield to a euro-era record 6.40 percent on Aug. 5, prompting a vow from Prime Minister Silvio Berlusconi to balance the budget and the ECB to start buying the bonds. That helped push the yield to 4.87 percent by Aug. 18. Still, the nation’s borrowing costs jumped at subsequent auctions amid speculation of a Greek default.

Outstanding Debt

Italy had 1.6 trillion euros of outstanding debt as of Aug. 31, according to its treasury’s website, making it Europe’s biggest national bond market. It must pay 88 billion euros to redeem bonds and bills maturing in the second half of 2011 and 291 billion euros in 2012, according to data compiled by Bloomberg. Spain is scheduled to hold an election next month. Polls suggest voters will ditch the ruling Socialist party.

“The market is not looking at the fundamental data, it is focused on the debt crisis and political positions,” said Werner Fey, a fund manager at Frankfurt Trust Investment GmbH in Frankfurt, which oversees the equivalent of 6.5 billion euros of fixed-income assets. “At the moment there is a flight to quality and bunds are extremely expensive. We will see bunds trading sideways, with some fluctuations.”

To contact the reporters on this story: Lukanyo Mnyanda in Edinburgh at lmnyanda@bloomberg.net; Emma Charlton in London at echarlton1@bloomberg.net

To contact the editor responsible for this story: Daniel Tilles at dtilles@bloomberg.net.

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