Are the European bond markets attractive?

European fund management houses have enjoyed plenty of success in Asia but, according to one, acknowledge they have a long way to go in educating Asian institutions about the opportunities in the Eurozone bond markets.

Jean-Francois Boulier, who runs euro fixed income and credit at Credit Agricole Asset Management in Paris, recently toured Asia to speak with institutions about eurozone bonds. He says European bonds remain a hard sell, particularly among central banks, but the opportunity set is rapidly expanding.

"Europe is a little exotic for Asian investors," Boulier says. "And European capital markets are very bond-oriented while many Asian institutions are equity-heavy. But as an Asian bond market develops it will create more appetite for fixed income overall."

He says Europe has become an attractive destination for fixed-income investors: "It's no longer like the 1990s where issuers in Europe imitated German Bunds and investors just wanted to issue fixed-rate government bonds that converged into the euro," Boulier says. "We now have developed specialized markets not tied to government bonds. Inflation-linked bonds are now a Eu100 billion market. Corporate bonds are a Eu800 billion market, and high yield is Eu100 billion. Asset-backed adds another Eu500 billion. There are real opportunities to diversify."

In addition to Asian investors' traditional need for dollar exposure, they are reluctant to invest in euro-denominated bonds because of the currency exchange risk. Investors can hedge this, but it's expensive to do so as long as short-term interest rates in the US are 1% and in Europe 2%, because the main cost in hedging is the interest-rate differential.

Boulier expects hedging costs to decline, however, as the US Federal Reserve begins to raise the Fed Funds rate.

The European Central Bank lags the US by about a year in terms of interest-rate hikes, but it is likely to be quicker than the Fed to do so when inflation rises. The ECB's sole mandate is price stability, targeting inflation of 2%. If inflation heads toward 3%, the ECB will be more prepared to raise short-term rates.

That may bode poorly for bond investors, but Boulier also says interest-rate rises in Europe will be much more modest than what may happen in America. While yields on the US Treasury 10-year bond will probably go above 5% next year, he sees the European 10-year bond yield moving from 4.4% to 4.8% only. European investors today are on the sidelines, but Boulier thinks they will start to buy around the 4.5-4.6% yield, as they are desperate for returns and need the coupon.

Credit Agricole's portfolios are defensive, but not overly so. Clients' liabilities don't allow them to stay too short-duration, and it's costly. In Europe, the optimal position for long-term investors is in the six- or seven-year bond, he says.