Non-traditional bonds glow

REUTERS

A bull and a bear styrofoam figurine.

Forget the Fed, forget the ECB.

Who needs core debt when countries like Brazil, Sweden or South Korea are in rate-cutting mode but their bonds still offer decent yields?

Regardless of whether or not Federal Reserve Chairman Ben Bernanke signals more US bond-buying when he speaks at Jackson Hole later on Friday or the European Central Bank cuts interest rates or lays out its own bond-buying plans on September 6, the trend for countries across the globe to loosen policy to stimulate growth is expected to continue.

This is good news for the value of non-core countries' bonds, while the reduced yield that cuts bring often still beats that of the larger markets.

Two-year German Bunds are yielding less than zero and US debt is offering little more, while at the other end of the scale, Spanish and Italian debt carries emergency warning signals.

As a result, investors are scrabbling for investment-grade rated bonds with a few ounces more of flesh on their bones.

“There certainly has been a focus on non-core markets, outside the euro zone, US, UK and Japan,” said Guy Dunham, global head of fixed income at HSBC Asset Management.

“One thing is the low level of yields in these core markets, particularly in the euro zone. The other is a desire to diversify away, and not be exposed to the peripheral debt.”

Asian ex-Japan bond funds have gained net inflows of nearly $10 billion this year and over $30 billion has gone into global emerging market bond funds, according to Boston-based funds tracker EPFR.

Scandinavian bonds have also seen heightened foreign purchases this year.

Latest off the blocks to lower interest rates is Brazil, which cut by 50 basis points on Wednesday. Brazilian two-year debt yields are close to their lowest since January, but that is still more than 8 percent.

“Brazil ... offers high nominal yields with sound fundamentals,” said Sam Finkelstein, emerging market debt portfolio manager at Goldman Sachs Asset Management.

“From a structural perspective, emerging markets should be a larger weight in fixed income portfolios.”

Most market focus for next week is on whether ECB President Mario Draghi sets out a credible programme on Thursday to buy Spanish and Italian debt.

The ECB may also cut interest rates by 25 basis points to a new record low of 0.5 percent, but economists polled by Reuters are split, with 36 out of 70 expecting the bank to leave rates on hold. Only two weeks ago, there was a Reuters poll consensus for a 25 bps rate cut.

Others may cut rates first.

While most analysts expect no change to current rates of 1.5 percent at the Swedish central bank's next meeting on September 6, they do see a rate cut by the end of the year and a leading economic think tank this week forecast two rate cuts this year.

The crown currency has hit 12-year highs in safe-haven flight from the euro zone.

In Thailand, the majority of analysts also expect no change in rates of 3 percent at the central bank's September 5 meeting, but they are starting to think about the chances of a cut.

Analysts at ING forecast a 25 bps rate cut as early as next week, and the market is also betting on another rate cut later this month in South Korea, following a shock cut in July.

“We believe that the deteriorating macro picture will push Asian central banks to stay or become more dovish,” said Citi analysts in a client note.

Expectations are also growing that Poland will follow a move by Hungary this week and cut rates due to a worsening economic outlook, though maybe not as early as its September 5 meeting. Poland's central bank hiked rates only in May.

In a bumper period for rate decisions, Canada and Australia - other popular trades for diversifying bondholders - also hold policy meetings next week, along with Britain, though no changes are in sight here.

Many of the smaller bond markets have their problems, however, despite the falling interest rates, particularly in terms of liquidity and currency risk.

And if Draghi succeeds in putting a cap on Spanish and Italian bond yields, currently heading back upwards on jitters about his chances, investors may alter their views.

Dunham at HSBC Asset Management said he has a neutral position in Spanish and Italian debt.

“There does seem to be a much greater willingness to come up with a plan,” he said, adding that if Draghi pulled it off:

“We would see spreads in Italian and Spanish bonds come in, mostly in the front end, we would see higher yields in US Treasuries and Bunds and probably higher yields in Sweden and Denmark.” - Reuters