Download Vontobel Group Euro-zone government bonds — a "broken" asset

Vontobel Group
Market Comment / May 2012
Euro-zone government bonds — a "broken" asset class
According to the old "eat well or sleep well" stock market adage, government bonds are
tantamount to a safe investment. But nothing seems further away from the truth given the
ongoing turmoil in the European Monetary Union (EMU). This raises the question what euro
investors should do with the supposedly safe part of their portfolio.
The introduction of the euro in 1999 allowed for interest rate convergence and substantial crossborder lending; disparities in productivity and GDP per capita seemed to decrease while the
European Union enjoyed ever-closer economic integration – until the implosion of the credit
bubble in 2008 laid bare the uncomfortable truth: much of the economic miracle, especially in the
periphery of Europe, had been built through excessive debt. As a result, imbalances grew to
unsustainable levels. In 2012, Greece has basically defaulted on its private debt, Ireland and
Portugal are being rescued by the International Monetary Fund and the European Financial
Stability Facility, while Spain finds itself in a truly dismal economic situation. In addition,
politicians in France and the Netherlands are questioning the merit of austerity without growth.
We believe that market participants underestimate the political risk associated with the euro
project as most of its key benefits are being eroded: instead of convergence, we are witnessing
growing interest rate divergence between Germany and the other members of the euro zone,
cross-border lending has all but vanished and market volatility has risen to such a point that one
has to examine the rationale of investing at all. On the one hand we have 10-year Bund yielding
1.7%, not reflecting strong German fundamentals but the logical fear of an EMU break-up. On the
other hand, a number of markets depend, directly or indirectly, on the European Central Bank's
extraordinary measures to boost liquidity. In such an environment, international market
participants essentially abstain from investing.
The euro-zone government bond market, an asset class worth four trillion euros, has an A+ rating
with a running yield of 3.9% (excluding Germany). France, Italy and Spain together account for
more than 70% of that market. This compares with a BBB- rating and a running yield of 5.4% of
the external debt market of emerging countries (JPMorgan EMBI Global diversified). We strongly
suggest that investors consider emerging-market external debt as an alternative given superior
diversification, positive rating dynamics and a higher yield. This asset class is denominated in US
dollars so there are no hedging costs.
Overall we remain cautious on equity markets given an unattractive risk-reward balance. The
companies' first-quarter earnings reports mostly beat market expectations, especially in the US,
Vontobel Group
Gotthardstrasse 43
CH8022 Zurich
Telephone +41 (0)58 283 59 00
Fax
+41 (0)58 283 75 00
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helping to contain the correction which started in early April. It is fair to assume that this should
limit the downside risk going forward. However, US companies likely won't escape the effects of
the necessary fiscal adjustment which should start in earnest in 2013. The impact of fiscal
austerity in Europe on companies, either via higher taxes or adverse regulatory amendments, is all
too visible. We do not consider government bonds of so-called developed countries as a palatable
alternative and we stick to our underweight stance, keeping cash at above-average levels until
opportunities arise. We have a clear preference for high-yield corporate bonds and emergingmarket debt.
Even though the US economy is growing at a decent pace and job creation has been significant
over the last six months, Federal Reserve chairman Ben Bernanke has not ruled out additional
monetary easing measures if need be. In such a scenario, gold would probably break out of its
six-month consolidation pattern to aim for new highs.
Christophe Bernard
Chief Strategist, Vontobel Group
Vontobel Group
Gotthardstrasse 43
CH8022 Zurich
Telephone +41 (0)58 283 59 00
Fax
+41 (0)58 283 75 00
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Vontobel Group
The Vontobel Group is an internationally-oriented Swiss private bank. The family-owned bank was first
established in Zurich in 1924. Vontobel specializes in wealth management for private clients and asset
management for institutional investors, as well as in investment banking. As of 31 December 2011, the
Group held CHF 132 bn of assets. Around 1,500 employees worldwide provide first-rate, customized services
for clients with an international focus. The registered shares of Vontobel Holding AG are listed on the SIX
Swiss Exchange. The Vontobel families and the Vontobel Foundation hold the majority of shares and votes
in the company. www.vontobel.com
Vontobel Group
Gotthardstrasse 43
CH8022 Zurich
Telephone +41 (0)58 283 59 00
Fax
+41 (0)58 283 75 00