U.S. money managers are predicting good things from the looming European monetary union. But their clients aren't too sure.
High-yield debt from European companies, in particular, could be a way for investors to boost returns in international and global fixed-income portfolios, money managers said.
Traditionally, government-issued debt dominated the European bond market. Such offerings by the Spanish or Italian governments promised investors rates of return close to 10%.
But with European nations paring debt over the past couple of years and balancing budgets to gain admission to the European Monetary Union, such offerings don't yield as much as they once did, said Edward D'Alelio, chief investment officer, core fixed income, for Putnam Investments in Boston.
"With the anticipation of countries converting to the EMU, the bond markets are trading more closely," Mr. D'Alelio said. He estimated yields on such sovereign issues have fallen to 5%.
Smaller European companies that have regularly gone to banks for financing are expected to make up the difference, though.
When 11 countries, including Germany, Italy and France, form the European Monetary Union Jan. 1, companies with smaller capitalizations -- and greater debt -- likely will be the issuers of the high-yield paper, Mr. D'Alelio said. He added high-yield spreads typically are 400 basis points to 500 basis points above 10-year U.S. Treasury securities.
Putnam is slated to add one research analyst to its fixed-income team in London to study the European junk-bond market.
Although the European corporate bond market will take years to develop, institutional investors on both sides of the Atlantic could use the growth in high-yield corporate debt to boost fixed-income returns, money managers say.
In the past 12 months, close to $10 billion in high-yield corporate debt was issued in Europe, said Christopher Durbin, managing director, head of European fixed income, at J.P Morgan Investment Management in London. That's compared to the $137 billion issued in high-yield debt in the United States in 1997.
To watch the new market, J.P. Morgan added two analysts to its credit research team and created a quantitative analystics team, Mr. Durbin said.
Some U.S. pension funds are closely watching the developments in the European bond market.
The EMU presents "significant changes in fixed-income markets," said Walter Koziol, director of investments for the Illinois Municipal Retirement Fund, Oak Brook.
The $12.6 billion fund will invest in European bonds "opportunistically," Mr. Koziol said.
He added Illinois Municipal has given its U.S.-based core fixed-income active managers the "flexibility to invest in nondollar denominated securities." The fund has a U.S. high-yield fixed-income mandate of $645 million, which is part of its $3 billion overall U.S. fixed-income allocation. In its fixed-income portfolio at the moment, Illinois Municipal "does hold European securities, but they're primarily government" paper, Mr. Koziol said. It has no European corporate junk bonds, he said.
"A high-yield fixed-income market will exist after the European Monetary Union. It will become available to our bond managers," Mr. Koziol said.
The number of European high-yield bond deals so far in 1998 totals 34, up from 11 in 1997, said Preston Peacock, vice president, Merrill Lynch Portfolio Strategy Group, New York.
Because of client demand, Merrill Lynch launched four indexes at the end of July to track the nascent European high-yield market and its growth, Mr. Peacock said.
"It became clear to us this is a rapidly growing market people are curious about," he said, adding the indexes are heavily weighted with telecommunications and media companies. In 1998, close to $7.5 billion in corporate high-yield debt has been issued so far, Mr. Peacock said. "That's starting from practically zero," he said. Before 1998, U.S. companies operating in Europe had issued corporate debt in dollars, he said. But this year, companies are floating paper in deutsche mark, sterling and European currency units.
While closely watching changes in European debt markets, other pension funds have not set an investment strategy such as Illinois Municipal.
"At this point in time," the $82 billion Florida State Board of Administration has "no specific strategy" for investing in the European bond market, said Debbie McCoy, a fixed-income portfolio manager for the Tallahassee-based board. She added, however, the fund is watching the potential for a market to develop.
Earlier this summer, Ms. McCoy started researching the burgeoning European bond market. But she is far from reaching any firm conclusions about investment opportunities there. "Up until now, (the Florida State Board) tactically entered" and "played" European bond markets, Ms. McCoy said. She added, however, that it does not have an international fixed-income allocation of a mandated amount.
Other funds, however, are avoiding exposure to global fixed-income markets, including the European debt market. Earlier this month, the $105 billion New York State Common Retirement Fund, Albany, shifted $821 million from global bonds to an internally managed domestic fixed-income portfolio. The fund's board decided against exposure to global bonds and "at this point, is not looking" at the European bond market, said Jeffrey Gordon, spokesman.
The potential for U.S. investment is sizable. U.S. tax-exempt funds such as pension funds and endowments have roughly $600 billion in assets overseas, with close to $100 billion -- roughly 17% -- invested in fixed income, said Chris Nowakowski, president of InterSec Research Corp. of Stamford, Conn.
Will this change in the future? Mr. Durbin of J.P Morgan said a lot depends on the dollar vs. the euro, the new monetary unit of the EMU. If the U.S. dollar weakens against the euro, "the currency return could enhance the fixed-income returns," he said.