The time of the great reversal is approaching. Two forces that have driven up the yields of the bonds of marginal European countries — particularly Spain, Italy and, of course, Greece — and driven down the yields of U.S. and Canadian government bonds look like they will unwind and create a new scenario for exceptional gains. This means you will need a new game plan for generating returns for your clients.

The single greatest force in bond markets in 2011 — the flight to safety from European sovereign debt — appears to be ready to relent. Says Nigel Roberts, a chartered financial analyst who heads money-management firm Bluenose Investment Management Inc. in Oyama, B.C.: “When the European situation has passed its peak crisis mode, then money will flow to Europe to tap high yields and into equities.”

That flow — for now, just a trickle into stocks and Italy’s and Spain’s sovereign bonds — has begun. The Euro STOXX index, a broad list of eurozone companies, rose by 5.4% in the first three weeks of 2012 after dropping by 15% in 2011.

As European stocks have gained, panic pricing of Italy’s and Spain’s 10-year bonds has eased, dropping yields to slightly more than 6% from 7% and to 5.4% from 5.8%, respectively. The market appears to be accepting the idea of Greece’s bond default, with only the details and the amount of the losses to be worked out. (Current speculation holds that the haircut that holders of Greece’s sovereign bonds will take will be 50% — or more.)

SHIFT AWAY FROM SAFETY

The new mood is likely to reflect a renewed taste for profit and a shift away from safety at any cost, says John Carswell, president of Canso Investment Counsel Ltd. in Richmond Hill, Ont. He predicts that European bond traders will find appeal in short-term borrowing from the abundant liquidity supplied by the European Central Bank at 1% a year and buying Italy’s or Spain’s bonds at 5% or more — even with a little default risk.

“It’s a great time to be buying if you have the stomach for it,” Carswell says. “We think the assets [formerly] shunned will prove to be great value going forward.”

In contrast, sticking with the safe havens of U.S. and Canadian government bonds could be a bad move, says Chris Kresic, co-lead for fixed-income and partner with Jarislowsky Fraser Ltd. in Toronto: “We could see 10-year government yields in both countries rise close to 3% from 2% today. The 10-year bonds have an eight-year duration. That would mean an 8% loss on the bonds’ value, reduced by the 2% coupon yield — for a net loss of 6%. If Germany’s 10-year bund with a nine-year duration sees its yield rise as money flees that haven, the return would be a 9% loss on face value, reduced by the 2% coupon — for a net loss of 7%.”

Moving to European debt will mean giving up the safety that U.S. and Canadian government bonds had provided last year. Those investors who took shelter in those bonds accepted historically low yields on U.S. treasuries and Government of Canada bonds. The 10-year Canada finished 2011 at 1.9%, a lower return than at any time since 1945. At the time of writing, the Canada has a yield of 2.07%, about the same as that of the U.S. 10-year T-bond.

Thirty-year Canadas have recently been priced to yield 2.66%, which gives a paltry 0.16% real gain over the Bank of Canada’s target inflation rate of 2.5%. The yield on U.S. Treasury inflation-protected bonds is even lower. At the time of writing, the 10-year U.S. Treasury TIP was trading at a yield of minus 0.03%. And negative returns or returns close to zero are not sustainable.

CAUTION CONTINUES

On Jan. 25, the U.S. Federal Reserve Board’s open-market committee said: “Economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through 2014.”

So, staying in U.S. government bonds that pay less than the Fed’s predicted 2% inflation rate will achieve only a negative real return. And, historically, the BoC doesn’t deviate too far from U.S. policy.

The issue now is whether to be safe with the puny returns on U.S. and Canadian government bonds or take a chance on coupon yields two to three times higher on the European sovereigns; with the latter bonds, your clients would have a chance at massive capital gains when Italy and Spain demonstrate that they can pay their bond obligations. At that point, the nibbles on bargain-priced European bonds will turn into a feast.

“Investors’ problem is to get a feeling of confidence to produce a first wave of buying of European bonds,” says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax. “[In January,] we saw spreads in European markets narrow. Spreads on Italian bonds are 350 basis points over German bunds, and Italian spreads are around 400 bps.”

But caution continues to rule. “The European bond market is cheap, but it’s cheap for a reason,” says David Rosenberg, chief economist and strategist with Gluskin Sheff & Associates Inc. in Toronto. For now, he says, the consensus is pessimistic — and the optimists have the profit opportunity.

The question remains: when should you move your clients into European bonds?

“The U.S. and European economies will do better than expected,” Kresic predicts. “That implies a rise in the entire yield curve. And in Europe, better business implies rising tax revenue and reduced default risk on European sovereign bonds.”

On an Italian 10-year bond priced to yield 6.2%, with a 7.5-year duration, a 1% drop in interest rates, driven by greater confidence, would create a return of 7.5% on the bond’s price plus the current 6.5% coupon — for a total return of 14%.

The new safe place to be could be Italy’s and Spain’s recovering bonds, Kresic says. Handsome gains would reward those among your clients who are on the right side of that trade. IE