Portfolio managers disagree on whether convergence, a profitable theme for investors in the global bond market in 1996, will continue this year.
Convergence is the tendency for interest rate spreads between countries to narrow over time.
"We are toward the end of the party," said Pam Burgess, director-fixed income, Prudential Portfolio Managers, London.
"We are not following headlong after a convergence strategy."
The Prudential group manages 12 billion pounds ($19.5 billion) in fixed income.
Theo Hillen, director, Lombard Odier International Management Services Ltd., London, has an alternative opinion: "We still think convergence will continue."
Anthony Robinson, head of non-U.S. investment strategy at Brinson Partners Inc., Chicago, is less sanguine.
"We have yet to see convergence in the global bond markets," he said.
Olaf Rogge, director and chief investment officer, Rogge Global Partners, London, expects convergence to continue in Europe in the first half of this year.
But Mr. Rogge said it depends on the exchange rate among European currencies, particularly the French franc to the German mark.
Dick Howard, director-economic research, Julius Baer Investment Management Inc., London, has a mixed answer.
In a recent research report he co-wrote, he notes, "In Europe there is modest scope for further convergence near term, but in the dollar bloc (the United States, Canada, Australia and New Zealand) the story may be yesterday's news."
In an interview, Mr. Howard said: "The general trend to convergence worldwide has arisen out of the economic paradigm of the 1990s: to bring budget deficits down and inflation down." That idea includes economic deregulation and privatization, using market forces to signal the most efficient allocation of functions that were in the public sector, such as many utilities, he said.
It also includes financial deregulation and reducing the size of government.
This model is being adopted around the world, helping to cause convergence, he said.
A big factor has been inflation reduction.
"Inflation has converged at a low level so we have had bond market convergence," he added.
Portfolio managers agree, saying a tendency toward convergence has occurred as markets around the world aligned their economies more closely. That alignment included similar monetary-policy restraints, declines in inflation levels and economic growth prospects.
"From a global perspective, the convergence of inflation is a big factor" in bond market convergence, said Ms. Burgess.
"Lower inflation makes us more confident yields will stay lower."
Stability helps further convergence.
"Economies tend to converge more in times of stability than in periods of boom-and-bust management," she added.
"We think we're in a stable period where inflation will continue to be lower," she added.
As a result, she contends, "interest rates likely will peak at a lower yield than they have before," giving more stability to the bond market.
For proponents of this continuing trend, convergence means they "are willing to accept less return, less yield because they perceive better economic and monetary management," Ms. Burgess said, echoing comments of other portfolio managers.
One of the most telling examples of convergence has been Italy, Ms. Burgess said. In the Italian bond market, spreads to the benchmark German bonds have narrowed some 400 basis points in the last couple of years. The spread has dropped to 150 or 200 basis points from 600 basis points.
"A lot of that is due to investors' belief that Italian authorities are determined to enter the European monetary union and become an initial member of the union" that could give participant countries a single currency in 1999, she said. This goal is behind the Italian effort to manage the economy better.
"Yields have converged more than most would have guessed," she said.
With a total publicly traded bond market of $1 trillion, Italy is big enough to have a significant impact on global bond portfolios, especially if there are prospects of its higher yields converging on the German benchmark.
Convergence in Italy could continue this year, she said.
"If you think that domestic economic policy will be run under EMU restraints (calling for, among other requirements, reduced budget deficits) and that there will be a common currency, the only diverging factor left will be credit spread," she said. That spread could be less than 100 basis points.
But she cautioned: "You could lose a significant amount of money if convergence doesn't continue," she added.
Convergence isn't a dominant theme at Prudential this year. "We think the risks are bigger than the return," she said. "But the risk depends on the market."
In the United Kingdom, "convergence isn't meaningful," even though 10-year bonds trade at a 180 basis-point spread vs. German bonds.
A major reason is "the U.K. government is prevaricating on whether it wants to participate in the European monetary union," she said. "Many in the short term don't want to see the U.K. lose its pound."
Brinson's Mr. Robinson pointed out the bond markets that are tending to convergence are mainly in continental Europe.
"Japan does very much its own thing," he added.
The continuation of convergence in Europe "will depend on whether the European monetary union will occur in 1999," he said. "Our best guess is it will."
Mr. Robinson cautioned about reading economic prospects based on EMU. "The reasons for the EMU are political," he said. "The economic advantages of the EMU are far from clear cut. Because the EMU is political, the criteria may be fudged to allow those countries that France and Germany want to be members."
"Every country is engaging in accounting tricks to move toward the EMU," he added. "The prospect of the EMU is one of the key factors driving convergence."
The United Kingdom might stay out of the EMU. Its bonds haven't converged as much, he said. "The U.K. was the only major bond market that had a rise in rates last year," he noted.
Brinson's portfolio is underweighted in Spain and neutral in Italy.
Convergence isn't necessarily long lasting, he warned. "In early 1994, the spread in Spain, Sweden, Italy" - all traditionally high-yielding markets - "narrowed to 160 basis points," before shooting back up again to some 500 basis points. "So we've been down this path before."
Lombard Odier's Mr. Hillen said three things could stop convergence, dismissing another factor, inflation rise, as unlikely. One factor is if interest rates pick up. Another is if the EMU can't go ahead in two years as hoped because the countries can't comply with the fiscal and monetary criteria. The third factor is if the German economy is too strong, putting pressure on other countries.
Julius Baer's Mr. Howard said convergence is a function of three basis factors in bond pricing. One factor, real yield, is a function of real growth. As economic growth improves in countries, their real bond yields move toward convergence. Another factor is the inflation component. Inflation has tended to be lower around the world, contributing to convergence. A third factor is the risk premium on bonds. Because credit risk remains in international bonds, this aspect of the market won't converge as much.
"The opportunities for outperformance by higher yielding markets are diminishing," Mr. Howard said. He expects convergence in Italy to continue and the spread to narrow to 40 or 50 basis points to German rates.
Mr. Rogge said an uncertain factor in the convergence trend is exchange rates. Particularly, whether the French franc will be adjusted to the German mark before the start of the potential EMU. "The forward market believes the exchange rate will continue as it is," he said. But he isn't sure himself.
Without an adjustment, France and Spain could have an uncompetitive exchange rate to the deutsche mark.
"We think it will be sensible to have a final adjustment to make French exports more competitive with German" and improve French employment, he said.