Q&A: European Bonds: "A Win-Win Scenario"

Rick Deutsch sees corporate paper doing well in any climate

With global equity markets still volatile, many investors in Europe are turning to bonds. Taking advantage of the demand for fixed- income securities and record low interest rates, cash-strapped European companies and governments are rushing to tap the bond market to pay off debts. London correspondent Kerry Capell asked Rick Deutsch, BNP Paribas' head of European corporate credit research and strategy, for his market outlook.

Q: What's behind the growth in the euro-bond market, which last year rose to some $93 billion for corporate bonds alone?

A: There has been a lot of money looking for a home in Europe, and much of it has gone into the [corporate] credit markets. Low interest rates have led European corporations to tap the markets for cheap funding. They are able to lock in better rates for much longer maturities than if they simply borrowed from the banks. Total returns are generally anywhere from 3% to 4% for very low-risk debt in sectors such as utilities, to 6% for the average lower-risk corporate, such as Imperial Tobacco Group. In contrast, the total average returns on European sovereigns is generally under 4%.

Q: Why is there such a big market for euro-denominated paper?

A: Companies whose natural currency is the euro have been taking advantage of lower interest rates to issue debt. There are a lot of British companies issuing in euros as well, because the sterling market is relatively small and the euro market is much deeper and more liquid. And, as the euro has become an appreciating asset, U.S. investors have become more interested in buying corporate euro bonds. This is a big change from two years ago.

Q: What about the impact of rate cuts by the European Central Bank?

A: Recent rate cuts have opened the door for further cuts in the future. Corporate bonds should definitely outperform government bonds as investors, particularly pension funds and insurers, search for [higher] yield.

Q: Do you anticipate European bonds outperforming U.S. Treasuries?

A: Yes. On the macro side, the ECB has more flexibility to cut rates than the [U.S.] Federal Reserve. And in a rate-cutting environment, corporate bonds will almost always outperform.

Q: What are the most attractive areas?

A: We like telecommunications. As telecoms have started to generate free cash to pay down their debt, new issuance in the sector has declined and credit quality has improved. The sector's fundamentals are still improving and will continue to do so for the next six to nine months. The total return on France Télécom bonds since the beginning of 2003 has been between 10% and 24%. Similarly, Deutsche Telekom bonds have returned between 8.5% and 14%. We do not expect such robust returns for the remainder of the year, but we still expect strong performance.

Q: Which areas should investors avoid?

A: The more cyclical industrial sectors such as pulp and paper, aerospace, building materials, and some auto makers are likely to be in for a rough ride. [Tight] bond spreads for many companies in these sectors have become divorced from underlying performance fundamentals simply because their rarity offers diversity for institutional portfolios.

Q: How should investors play the deteriorating credit quality from rating downgrades?

A: The best strategy is probably to stay away from both the very top and very bottom of the market in terms of ratings. It may seem counterintuitive to warn investors away from very highly rated companies, but these outfits will very likely be downgraded over time as most corporate bonds eventually settle in the A to BBB range. We recommend portfolios containing less cyclical bonds such as telecoms and utilities.

Q: Will investors continue to snap up bonds this year?

A: It's really a win-win scenario. We think corporate bonds will perform very well whether the economy picks up or not. Even if the equity markets pick up, there will be demand for corporate paper.

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