It is proving to be one of the toughest calls of 2012: Buy or sell German Bunds?
Throughout the European financial crisis, German government bonds retained their haven aura, rewarding investors who clung to debt of the economic powerhouse. Now, though, many see a threat that measures taken to save the euro will leave Germany shouldering the burden, a negative for bond prices.
Even Wall Street is divided. In one camp are bond watchers at J.P. Morgan and UBS, who say they expect Bunds to keep rallying. They say Bunds will continue to be a harbor for investors as Europe struggles to resolve its debt crisis. In another are analysts at Goldman Sachs and Credit Suisse, who are expecting long-term Bunds to fall, which would push yields higher, as investors begin to fret about the toll any solution would take on Germany's finances.
Friday's sharp selloff in Germany's bonds scored some points for Goldman and Credit Suisse.
News that European leaders had agreed to press toward centralized control of fiscal policy was welcomed by many investors. But holders of German bonds focused on the potential for such a move to put German taxpayers on the hook for their neighbors' debts.
As prices for Bunds tumbled, the yield—which moves inversely—on the German 10-year note rose to 2.106% Friday, from 1.97% on Thursday, according to data from trading platform Tradeweb.
Throughout most of the crisis, bond-fund managers have dumped bonds of fiscally troubled countries such as Spain and Italy and stocked up on Bunds. Counting price gains and interest payments, Bunds had returned roughly 7.5% to investors in 2011 through Friday, versus a loss of roughly 10% for European stocks in the Stoxx Europe 600 index—including dividend payments. The Barclays Capital U.S. Treasury index gained 8.8% year to date, while Italian government debt posted a loss of 6.8%.
Bunds were "the only safe haven left" in Europe, says Michael Mata, head of multisector fixed income at ING Investment Management, which has $24 billion in assets under management.
But that has changed, Mr. Mata says. "The flight-to-quality bid in German bunds has definitely declined." He has joined the flight, selling long-term Bunds. He has been moving cash to some shorter-term German debt, which by definition isn't as exposed to longer-term worries. He has also used some of the cash from selling debt to buy other bonds he likes, such as emerging-market bonds denominated in currencies such as the U.S. dollar, which he says are less likely to be affected by events in Europe.
Signs of investor wariness about Bunds came in late November. As the euro-zone crisis intensified, investors began to grow leery of other triple-A rated bonds of European nations, and Germany had one of the worst 10-year bond auctions in its history.
Prices tumbled, and yields on 10-year bonds jumped to roughly 2.29% on Nov. 29, according to Tradeweb data. German yields climbed above those of U.S. Treasurys, suggesting that Treasurys were starting to pull ahead of Bunds as the preferred safety play for investors. That is something that happened during the worst of the financial crisis in late 2008 and early 2009.
Says David Rolley, co-manager of the Loomis Sayles Global Bond fund, which had $2.4 billion in assets as of the end of October: "If there is going to be a greater burden placed on the German taxpayer, these might not be the right [interest rate] levels to be lending to the German government."
The fate of Bunds is significant to more than just Germany. With yields at decades-long lows, bond prices can move wildly with rather small movements in yield. So for bond-fund managers, picking the right havens to buy can be the difference between big investment returns or falling far behind competitors.
Earlier this year, for example, a surprise rally in U.S. Treasury bonds wrong-footed some of the most vaunted investors in the bond markets, including Dan Fuss at Loomis Sayles & Co., and Pacific Investment Management Co.'s Bill Gross.
Goldman Sachs bond-market strategists recently spotlighted a "short" bet on Bunds—which pays off if prices fall—as one of their top trades of 2012. In a note on the trade, Goldman analysts argued that the largest so-called "core" euro-zone countries such France and Germany would increasingly be exposed to the debts of their neighbors.
"The 'shadow' credit risk of the core countries is already rising, and at an increasingly rapid pace," Goldman analysts wrote.
Not everyone agrees. Bond-market analysts at UBS, for example, argue that the European situation is likely to worsen until an all-out crisis—what UBS calls a "big bang"—forces a resolution.
Under that scenario, they expect increasingly startled investors to continue to flock to Bunds. J.P. Morgan European bond-market analysts also call for Bund prices to keep rallying. "All the drivers of our [10-year] Bund model point to lower yields in 2012," they wrote in their 2012 outlook report, citing not only flight-to-safety dynamics, but also a pessimistic view on euro-area economic growth, which they expect to prompt rate cuts from the European Central Bank.
Getting the call on Germany right is no small matter. With $1.44 trillion worth of tradable debt outstanding, Germany is the sixth-largest bond market tracked by the Organization for Economic Cooperation and Development. And German government debt has the fifth-largest weighting in the widely followed Barclays Capital Global Treasury Index.
read more: Olympus Wealth Management
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