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Bond funds reveal their euro strategy

Nick Rice reports on bond fund holdings amid the eurozone bailout turmoil

At least seven global bond funds revealed top 10 holdings in peripheral eurozone debt at the end of September, according to Trustnet, as Ireland’s financial woes accelerated towards a bailout.

Italy and Spain dominated the holdings, rather than Greece and Ireland, which have received a bailout from the International Monetary Fund and the European Union, in Ireland’s case, the European financial stability fund.

Managers avoided Portugal, which has a deficit of almost 10 per cent of GDP and is struggling to pass budget cuts.

Big portfolios which hold Spanish or Italian debt include the £753m Newton international Bond, the £423m F&C Global Bond, the £339.2m Threadneedle global bond, the £337m Old Mutual global strategic bond and the £199m Henderson overseas bond funds.

Investors fear demand for Spain and Italy’s debt may fall, even as their deficits supply the market with more debt. This dynamic would push down the value of the debt and push up yields.

Italian yields are already 4.2 per cent and Spanish yields 4.8 per cent, according to the Financial Times. Portugal’s is 6.8 per cent. The yield, which tends to set the interest rate on new government debt, is already close to the 5 per cent interest rate quoted for the IMF and the EFSF.

Spain had a budget deficit last year of 11 per cent of GDP – about £100bn. Unlike Portugal, it has passed severe cuts which are set to reduce the deficit to 9 per cent of GDP – around £85bn. Spain is proposing further measures to cut the deficit to 6 per cent of GDP in 2011 – £55bn. But its budget projections assume growth of 1.3 per cent next year.

Lombard Street Research regards Spain’s growth figures as too optimistic, given public spending cuts and unemployment, which is running at around 20 per cent.
Spain’s growth was non-existent in the third quarter but LSR expects it to dip in the fourth.

Spain’s banking sector is also receiving emergency funding from the European Central Bank, which limits the amount it can lend to the government and to the private sector.

Moreover, Spain has guaranteed over 10 per cent of all lending from the EFSF, around £44bn out of a total of £375bn.

If the EFSF contributes threequarters of the Irish bailout, as the EU did for Greece, Spain would be liable for £5bn-6bn of the debt in the event of a default or a restructuring.

Spain’s liabilities would rise by a similar amount in the case of a Portuguese bailout.

The prognosis for restructuring is uncertain. Irish institutions are agreeing voluntary restructuring with their creditors, according to announcements by Anglo Irish Bank last week.

Newton international bond fund manager Paul Brain says Spain is not growing fast enough for the budget cuts required. He has sold out of Spanish debt entirely.

Threadneedle global bond fund co-managers Dave Chappell and Martin Harvey say the Italian situation looks better and they have stuck with their holdings in the country.

Italy ran a deficit of just ove 5 per cent last year – £85bn. It has settled on budget cuts of over £21bn to reduce the deficit this year and next. Its banks are in better shape and have greater resources to fund the private sector and the government.

But Italy’s EFSF liabilities are double those of Spain. Its deficit will still supply the markets with more debt, potentially at a time of falling demand.

Overall, the managers conclude, neither Spain nor Italy would seek a bailout purely on the basis that their funding costs from the IMF and the EFSF would be lower.

If it bails out Greece and Ireland, the EFSF does not have the resources to bail out Spain or Italy where GDP exceeds £0.85trn in each country, according to the IMF.

The managers say they have 5 per cent in Italian government bonds maturing in two years, 5 per cent in five-year bonds maturing in five years and 1.5 per cent in 10-year debt.

If Portugal appears to require a bailout, they say they will review the position.

At the end of September, other bond funds’ exposure to the euro periphery was lower, within the limits of their top 10 holdings.

Old Mutual global strategic bond fund had a 3.8 per cent top 10 position in Spanish government debt. F&C global bond fund had a 3.6 per cent top 10 position, which it retained at the end of October. Newton international bond fund had 3 per cent exposure to Spain outside its top 10 but has sold out of its holding.

In Italian government debt, the Henderson overseas bond fund held a 5.2 per cent top 10 position, Threadneedle global bond fund 5.1 per cent and F&C global bond fund 4 per cent and Newton international bond fund 3.1 per cent.

Of the smaller funds, the £39.4m Swip global bond plus fund held 4 per cent and the £36m Fidelity international bond fund 1.9 per cent.

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