What to back as rates rise

Each week, a professional investor tells us where she'd put her money. This week: Rose Ouahba, head of fixed income at Carmignac.

Last year was a rocky ride in fixed-income markets. This year it is clear that interest rates in core European countries do not reflect the fundamental strength of these economies. Take the French presidential elections in May, which markets watched nervously following the recent wave of populism. We were confident that extremist parties wouldn't be perceived as the right ones to address France's many social and economic challenges.

However, markets took a cautious stance, and so German ten-year bond yields which are seen as the safe asset to hold in times of turmoil fell as low as 0.16% in April. Meanwhile, the "no more inflation" mantra gained traction, helping yields hit new lows.

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However, with economic data continuing to be strong in Europe, it's questionable whether this low-yield environment can continue. At the European Central Bank's (ECB) last meeting in Portugal, change seemed to be in the air. Investors are becoming less complacent as it became clear the ECB will join the US Federal Reserve in raising interest rates.

How should investors react to this? Rising rates in Europe will affect the whole fixed-income asset class, and in particular those parts of the bond market that have attracted short-term "tourist money" hunting for higher yields. Combined with tighter regulations imposed on banks and the kind of assets they can hold, the liquidity risk is ballooning. So we would take profits on high-yield credit markets in the US and Europe, as the risks are too great.

On the plus side, it seems that political will is back in Europe. We're optimistic about the renewed appetite for reform, which will give much-needed impetus to the European project and will benefit European non-core sovereign bonds.

The first wave of convergence between the bond yields of eurozone economies from the mid-1990s to 2000 was very powerful. In 2010 we saw a second phase, when yields diverged as the debt crisis engulfed Greece, Spain and Portugal. This third phase could lead to another strong wave of convergence. Investors should be long Italian, Portuguese and Greek government bonds.

In Italy, we particularly like the 2.2% BTP maturing in 2027. The yield curve (the graph of interest rates versus maturity dates) for Italian government bonds is quite steep and so these bonds offer a good carry (the difference in income between shorter-term and longer-term rates). We also like the 4.75% Greek government bond maturing in 2019. These may rally further if Greek bonds become eligible for the ECB's quantitative-easing programme.

There is also still value in emerging-market debt. This part of the market is supported by China's macroeconomic stabilisation, a rebound in commodity prices, improving current-account balances and higher yields than in developed countries. We favour commodity-linked countries for example, Brazil's current-account balance has improved significantly and structural fiscal reforms have improved public finances. Specific issues we like include the Brazil NTN-F 10%, maturing 1 January 2025, and the Mexico bono 8.00%, maturing 7 November 2047.

Rose Ouahba is head of fixed income at Carmignac Gestion