Bond Bubble in Europe?

Investors hunting safety may get hurt

The stock markets are closed to even the bluest of blue chips needing to raise capital, European commercial banks are loath to lend new money, and private equity investors charge extortionate fees. So where did German utility RWE go when it decided it needed $550 million in euros? Straight to the corporate bond market, where interest rates are near record lows and investor demand is at historic highs.

The Essen-based power, water, and recycling utility is in good company. It's one of 240 enterprises that have raised a record $148 billion by issuing euro-denominated bonds since the beginning of this year (chart). "There has never been such a strong appetite for corporate bonds in Europe," says Matthew King, head of European credit research at J.P. Morgan Chase & Co. in London. European pension funds, insurers, and other institutional investors, having lost a packet on equities, are piling into corporate fixed-income markets. The lure is the prospect of relative stability and tolerable returns--the average yield of an investment-grade corporate bond is 5.5%.

And the waiting line is long. Many institutions say they have temporarily parked billions of euros in government securities, which they will switch into new corporate bonds as soon as they can. Indeed, so many investors offered to buy RWE's securities that the company increased its issue to $817 million, and it could have borrowed $3 billion if it had wanted to. Power company Gaz de France, which sold $2.18 billion in bonds on Feb. 3, could have raised $9 billion.

To some financial experts, that means just one thing: A bond market bubble--inevitably to be followed by a bond market bust--is in the making.

How so? Start with sovereign debt, whose behavior often predicts how corporate bonds will fare. David Fuller, global strategist at Stockcube Research Ltd. in London, says euro zone government bonds are already oversold. Yields on German Bunds, the benchmark, have fallen from 4.92% to 4.02% over the past year. Although Fuller hesitates to use the word "bubble," he predicts "a shakeout in bonds." A quick end to the war with Iraq would hit government markets hard, he says. The equity markets would almost certainly revive, however briefly, leading investors to dump German, French, and Italian bonds. "They'd be wise to be out of government bonds once the offensive against Saddam Hussein gets under way," says Fuller. Even if stock markets fell again, he adds, the medium-term prognosis for bonds is bearish.

Carl B. Weinberg, chief international economist at High Frequency Economics, a consulting firm in Valhalla, N.Y., agrees. He argues that rising oil prices could boost euro zone inflation--already an uncomfortable 2.1%--squeezing returns on government bonds well below the 2% minimum that most investors consider acceptable. "The [government] bond market is set for a major correction," Weinberg predicts.

At first glance, the situation doesn't look as unsettling on the corporate front, where yields still average 2% above government levels. And some of the bond-issuing companies are better bets than Europe's governments. Alok Basu, senior credit researcher at Gartmore Investment Management PLC in London, points out that many of the companies now raising money are using it to cut their financing costs, replacing old high-interest bonds with new lower-interest ones. By lowering their interest expense, they are becoming more attractive to investors, even if yields are low. "Just look at telecom companies," he says. "A year ago, they were highly risky. But they've restructured themselves and are now in better shape."

A possible cut in rates by the European Central Bank could help big corporate issuers as well. Neil Carroll, head of institutional bonds at Dublin-based stockbroker Goodbody, says the European Central Bank could respond to slower-than-expected growth by lowering rates by up to 50 basis points during the next few months. "I really think there is more scope for bonds to outperform rather than underperform," he says.

Maybe. But probably not for long. Europe's larger economies may be hovering on the brink of deflation now. But European Union governments are quietly loosening the rules of the Growth & Stability Pact, which restricts the size of their budget deficits, and are spending more to get their economies going. That means inflation could spike, and when it does, the appetite for corporate bonds will wane. There are already signs of an overheated market. Yields on euro-denominated bonds have declined some 15% in the last year, sending prices and total return up sharply (chart).

Meanwhile, Washington is pouring money into the U.S. economy, the world's locomotive, by cutting taxes and pushing up deficits. If the U.S. starts picking up speed, as expected, later this year, its equity markets could jump. Europe's would quickly follow, and corporate bonds would suddenly seem a bad bet. "This could be the fourth consecutive year that bonds outperform equities," says Donald H. Straszheim, president of Straszheim Global Advisors Inc. in Santa Monica, Calif. "But I doubt it. Yields are too low. This is not Japan. Even Germany is not in a Japanese-type situation. Investors are taking a big chance buying bonds."

Things could come to a head even before Iraq plays out. The creditworthiness of Europe's telecom giants may be improving, but that's not the case for most companies. Rating agencies say they expect more downgrades than upgrades this year, and economists predict that there will be even more bankruptcies this year than last. A big, unexpected corporate collapse or ratings downgrade could spark a major bond sell-off across Europe. Already there are jitters in the recently developed market for 30-year corporate bonds, which has been shaken in recent weeks by poor liquidity and increased volatility. Deutsche Telekom and Électricité de France are just two of the large euro zone companies that have recently issued 30-year securities. Investors that snapped the debt up may live to regret it.

All this would be bad news for investors who have already been hit by the bust in the equity markets. And to make matters worse, a bond bust can last a mighty long time. "You're stuck with all those long-term securities with low yields on your books," says Fuller, "which is the last thing any investor wants when the economy is improving." Risky? Sure--but only if you're buying. "We are extremely delighted with our issue," says Peter Matza, senior manager in RWE's treasury division. The question is how long bond buyers will be delighted with their investment.

By David Fairlamb in Frankfurt

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