Seeking better fixed income returns? Check out European bonds

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Income investors with some appetite for risk, who are frustrated with the recent performance of North America's bond market, might want to look across the Atlantic.

European bonds – both government and corporate – have been rising in price for more than a year. They have weathered concerns about inflation far better than their U.S. and Canadian counterparts and have largely avoided the volatility experienced in North America this year.

With the Euro zone now emerging from a lengthy recession and governments working on structural reforms, "there seems to be a feeling that Europe is starting to move forward with the things it needs to do," says David Zahn, head of European fixed income at Franklin Templeton Investments in London.

Economic growth for the region as a whole remains very slow. But historically, slow-growth environments are good for bonds because they imply low inflation. In addition, the European Central Bank is floating new ideas for injecting more cash into the economy.

"On the whole, this is a strong backdrop for bonds," Mr. Zahn says, referring to both government and corporate debt. He is particularly bullish on "the peripheries" in Europe, especially Italy. But he views prices in Germany and France as too expensive.

European government bond prices have done extremely well over the past 18 months, with some issues registering double-digit gains as fears of a euro breakup have dissipated. The rapid rise has led some market watchers to question how much life is left in the run.

"I think the party is almost over," says Hank Cunningham, fixed income strategist for Odlum Brown Ltd. in Toronto.

But there may be more upside ahead for European corporate bonds as investors take their profits from government bonds, he says.

The corporate bond market in Europe has healed itself over the past 18 months, says Dave Sekera, director of corporate bond strategy at Morningstar in Chicago. A year ago, investors buying investment grade corporate debt demanded a return of 140 basis points (100 basis points equals 1 per cent) more than the yield on 10-year government debt. Today that margin has shrunk to just 112 basis points. In the U.S., spreads have tightened much less in the same period, from 140 basis points to 134 basis points today.

These are very favourable conditions for European companies to be floating new debt issues. New issuance of high-yield debt (commonly referred to as "junk bonds") has already hit an annual record and issuance of investor-grade bonds is rapidly approaching a high. Even North American companies are joining the party. Microsoft Corp. and Bank of America are two of the most recent players issuing debt in euros this month. In fact, U.S. companies have raised 39-billion euros from debt sales this year, compared with 20-billion euros in 2012, according to Bloomberg data.

Among domestic issuers, banks have been particularly busy. Last month, for example, Austria's unit of Italy-based UniCredit SpA sold 500-million euros of bonds and France's Societe Generale SA sold 1.5-billion euros worth of debt.

While there's certainly no question that in Europe it is a debt-seller's market, there are still numerous good reasons to consider buying high-quality corporate debt from the region.

The trend of falling bond rates in Europe suggests momentum for rising prices (bond rates and prices move in opposite directions). In the U.S. and Canada, the opposite situation exists.

Consider that in May, shortly before the U.S. Federal Reserve floated the idea that it would taper its monthly bond purchases, the yield on 10-year Treasuries was just 1.6 per cent. By September it had surged to a high of 3 per cent. Investors took the Fed's language to mean that inflation was around the corner. Although the central bank has since gone to great lengths to say it is not worried about inflation, the seed of worry has been planted in the market.

In Europe, inflation fears are not weighing down bond prices. In fact, the new concern is deflation. In the past two months, Europe's annual inflation rate has dipped below 1 per cent, hitting 0.9 in November and 0.7 in October. Those levels are less than half the ECB's inflation target of 2 per cent. Without the threat of inflation eating into slim bond returns, European investors are more likely to remain bullish on the local corporate bond market.

If deflation does emerge, the price of high-quality corporate bonds could see a pop, Mr. Sekera says. That's because the interest rates on existing debt would become more attractive. But investors would need to be agile in such a market, where any gains would be short term.

Once deflation sets in, companies find it hard to increase revenues and profits and the weaker players eventually find it hard to service their debt.

For the moment, however, deflation represents only an emerging fear for Europe. The important point for investors of European bonds is that the region will enjoy low inflation, and low interest rates, for at least another one or two years, Mr. Zahn says.

Meanwhile, there is actually growing optimism for corporate performance. Last month, 59 per cent of European fund managers polled by Bank of America Merrill Lynch said they expect the region's companies to boost profits in 2014. That figure was up from just 49 per cent in October.

With unemployment next year expected to top 12 per cent, Europe's economy has little to brag about. But the euro zone has crawled out of recession and the region as a whole is registering growth for the first time since late 2011. The ECB cut its short-term lending rate to a record low of 0.25 per cent in November and economists are forecasting GDP growth next year of 1.1 per cent.

That data should help the bond market. But investors must remain selective when it comes to European corporate bonds, paying close attention to debt levels and the ability to manage interest payments. Telecom Italia, for example, has been downgraded by both Moody's and S&P in the past month, with the rating agencies expressing concern about the company's "elevated leverage" and its overreliance on the domestic market for business.

European financial institutions demand particular caution, Mr. Sekera warns. "We just don't believe that European banks have improved as much as investors have given them credit for," he says.

Share prices in Europe's banking sector have risen 66 per cent since July, 2012, when ECB President Mario Draghi vowed to do "whatever it takes" to save the euro currency. Since that time, the banks have improved their regulatory capital ratios significantly, but not enough to get them out of perilous territory, according to Erin Davis, Morningstar's senior analyst of global banks. She warns that with tangible common equity ratios of less than 5 per cent on average, the banks remain highly leveraged.

The questionable strength of the financial sector makes navigating European debt markets more difficult. But for the savvy, agile investor, European corporate bonds could present a lucrative opportunity, especially as an alternative to North American bonds.