Some See Hidden Treasure in European Bonds

Now that the U.S. economy appears to be firing on all cylinders, most market strategists are convinced that the Federal Reserve will raise interest rates in 2004, perhaps even before the November presidential election.

If you have any doubts, just take a look at the Treasury market and its reaction to recent events.

The yield on the benchmark 10-year Treasury note touched 4.33% Tuesday, a far cry from the 3.65% of March 17, which was the lowest since last July.

The latest spike in rates Tuesday followed data that showed surprisingly strong retail sales in March. The retail report added to the newfound confidence about the economy's recovery that was triggered by the burly payroll report released earlier this month.

Meanwhile, those same strategists predicting higher U.S interest rates also expect the European Central Bank to lower its primary lending rate soon, to soften the blow of the weak dollar and a subpar recovery there.

Given those fundamentals, you'd think the smart money would be heading east to cash in on an anticipated run-up in bond prices, but as is sometimes the case on the Continent, political factors have some strategists thinking twice.

Donald Quigley, portfolio manager for the $80 million Julius Baer Total Return Bond Fund ( BJBGX), is not one of them. He says it's time to take advantage of the outlook on U.S and European interest rates by increasing your portfolio's exposure to European bonds.

"Due to Europe's inability to raise rates, we are buying European debt at the longer end of the yield curve," says Quigley. "The yield is decent, and there's less likelihood that the price will be going down compared to U.S. bonds."

Right now, the German 10-year bond, widely considered the benchmark for Europe, is yielding 4.07%, and the French 10-year bond is just 2 basis points below it at 4.09%.

One of the wild cards when it comes to international investing, however, is currency risk. Jack Malvey, chief global fixed-income strategist at Lehman Brothers, warns investors looking to dip their toe into European bonds to be cognizant that "currency bands will swing wider than the 1%-2% pickup in yield" they might expect to gain.

Over the past year, the euro went from 1.06 in April 2003 to a record high of 1.29 in February 2004, though it's now near the 1.20 level. Nevertheless, the common European currency is still up about 50% from its 2000 low of about 82 cents to the dollar.

In his fund, Quigley says he is hedged in some instances, but on the whole, he sees the European common currency appreciating back to its record high, something that would help goose returns even further.

John Krey, senior investment officer at Standard & Poor's, expects the ECB to cut rates 25 basis points in the next few months, but he suggests that investors looking to make a move into Europe stick with shorter durations on the European yield curve, since "the impact will be felt closer to the rate that's being cut."

"Any central bank has its greatest control at the short end of the curve," says Krey. "When you get to the long end, other factors like credit quality come into play."

In Europe's case, Krey has concerns about long-term credit quality based on what he sees as an inability of the three cornerstones of the European Union -- Germany, France and Italy -- to curb their spiraling budget deficits.

"It causes great concern when the three core countries are out of step with ... deficit provisions of 3% of GDP per country," says Krey, referring to one of the central fiscal criteria for qualifying for membership in the common currency.

All these reasons and more are why Subodh Kumar, chief investment strategist at CIBC World Markets, sees better opportunities in the U.S. or the U.K.

Like Krey, Kumar is unsure of Europe's ability -- both individually and jointly -- to confront its mounting deficits. He's also less confident about the ECB's capabilities compared to those of the Fed, which he describes as being "far more proactive" in its methods for changing interest rates.

Kumar also says there is room for the dollar to improve, since currencies move "on various things, not just interest rates." For example, he points to the terrorist bombings in Madrid and the political situation in Europe, which he describes as "no better than the U.S. and maybe worse."

"When people sense that global growth is improving, the higher coupon won't help you, since the difference between the U.S. and Europe at the long end of the yield curve just won't be that large," says Kumar.

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