Republished from Reuters: “Bond Funds Find Yield in Europe’s Mine Field”

By Tim McLaughlin
BOSTON, March 7 | Wed Mar 7, 2012 1:34pm EST
(Reuters) – Don’t write off Europe’s chaotic bond market just yet – at least not all of it.

Some U.S. bond fund managers say investment-grade corporate debt from Italy and Spain is a “sweet spot” for picking up reliable yields at junk bond prices.

To be sure, it’s a contrarian investment play on a continent whose sovereign debt crisis threatens to disrupt the cash flow of even the most robust European corporations.

Nevertheless, the $14 billion Loomis Sayles Strategic Income Fund is making small bets on the bonds of European telecom and utility companies pegged to the dollar.

“We believe those cash flows are not at risk,” said Kathleen Gaffney, a top bond manager at Loomis Sayles. “People will continue to keep their lights on and talk on the telephone.”

Buying debt denominated in dollars instead of euros helps reduce some exposure to the continent’s deep-seated problems. For bonds that pay out in euros, the higher yields from savvy security selections could be wiped out by currency moves.

Prospects for reducing Greece’s crushing debt load improved on Wednesday after 30 major banks and pension funds said they would join a proposed bond swap offer.

Investors are scouring the globe for higher yields. Multi-sector income funds in the United States have had net inflows of $30.6 billion over the past two years, according to Lipper, a Thomson Reuters company. Net assets in the category totaled $118.5 billion at the end of January, compared with $73 billion two years earlier.

The Loomis Sayles fund has outperformed its peer group for the past decade, racking up a 10-year annual total return of 10.79 percent, compared with the group average of 6.68 percent, according to Lipper.

Corporate bonds in Germany and France, two of the more stable European economies, are not attractive to Gaffney and her team because the yields have not been pushed up much by the crisis. This week, for example, the spread on a German utility bond against the yield on U.S. Treasuries was 91 basis points while comparable bonds in Spain and Portugal had spreads of 225 basis points and 670 basis points, respectively.

“The sweet spot is Italy and Spain,” Gaffney said. “We continue to be buyers of telecoms and utilities.” She said the fund has found yields of 7 percent or more.

In recent months, the Loomis Sayles fund has disclosed small holdings in the bonds of Telecom Italia Capital SA and Telefonica Emisiones SAU, for example.

Bill Kohli, co-head of fixed income at Boston-based Putnam Investments, is finding both investment-grade and junk debt of European companies that he said have been overly penalized because of their location.

“It’s not because of a weak company,” Kohli said. “We think even below investment-grade debt could be attractive.”

Some fund managers, however, see danger rather than opportunity in European corporate bonds.

Mike Cirami, a portfolio manager on Eaton Vance’s global fixed-income team, said the wider credit spreads that have attracted some investors should be seen as more of an imminent warning sign.

“If bond spreads are trading at junk levels, it may be that the credits are more like junk,” Cirami says. “It’s a more difficult environment for corporates. Sovereigns can go after corporates to protect their creditworthiness to the detriment of the corporates.”

Actions could include increased taxation and, for utilities, price cuts imposed by regulators. And any extended sovereign weakness could impair corporate access to refinancing, Analysts at Goldman Sachs last month said European telecoms face painful choices, such as asset sales and cutting capital spending and shareholder dividends, to reduce their leverage.

In addition, there would be another level of risk in European corporate bonds if their respective countries were to decide they didn’t want to stay in the European Union.

Loomis Sayles’ Gaffney said there is a huge incentive to keep the European Union together. A worst-case scenario would be if Italy and Spain left the union and returned to their prior currencies.

“You would then see huge devaluation,” she said.