A Surprising Opportunity Abroad

OCEAN CITY -- In today's low interest-rate environment, the search for higher-quality, higher-yield fixed income can sometimes seem like a fantasy. While low-risk standbys such as 10-year U.S. Treasury bonds and 10-year German bunds offer principal protection at their current yields of 1.8% and 1.5%, respectively, barely beat current inflation. Recently, bonds issued by some European countries offer more attractive yields, but considering the serious economic problems the Eurozone continues to face, it's important to note that they often carry much higher risks than relatively steadier options.

There is, however, an alternative that can offer attractive yields as well as lower risks: European supranational bonds, which are issued by organizations owned and capitalized by multiple European nations — entities such as the European Investment Bank (EIB), the Council of Europe Development Bank (CEB) and the European Bank for Reconstruction and Development (EBRD). The groups issue debt denominated in U.S. dollars as well as euros and other currencies to support everything from Eurozone recovery efforts to lending by local and regional European banks.

"During the past few years, supranationals have been hit by fears of a Eurozone breakup," says Ralph Axel, a bond analyst at BofA Merrill Lynch Global Research. Those worries, he notes, have kept the prices of supranational bonds down and their yields up—despite a generally low risk that the bond issuer will fail to meet their obligations.

Indeed, the market frequently paints supranational organizations with the same brush as the individual European nations issuing sovereign debt. But supranationals hold assets from across the Eurozone, thereby diversifying risk. Although the advantage of supranational bonds over Treasuries has narrowed in recent months, many of these investment vehicles may potentially still provide solid income combined with high quality, and can in turn add diversification to a fixed income portfolio, Axel says.

"The EIB hasn't experienced a loss throughout the Eurozone crisis," Axel says. Its lack of bad loans, even now, testifies to how carefully the organization screens its borrowers and runs its operations, he observes. That said, its bond prices run the risk of volatility, even if the likelihood of outright default remains low.

Like any other investment in today's turbulent markets, supranational bonds experience their share of ups and downs — and that, in turn, may give investors a chance to find attractive yields. In May, for example, EIB bonds denominated in U.S. dollars offered yields almost a percentage point higher than those of comparable U.S. Treasuries. Markets punished the EIB bonds—pushing down their prices, which increased their yields—because of the Greek, Italian and Spanish loans on the EIB books.

As Axel points out, the Standard & Poor's and Moody's Web sites, along with Merrill Lynch's analysis tools, provide a wealth of information about each supranational's strengths and weaknesses, including the types of loans on which it focuses.

Despite a diminishing income advantage over Treasuries and other high-quality bonds, supranational bonds are currently trading at prices lower than historical averages. Although they're prone to volatility as the Eurozone crisis continues, such turbulence may give investors a chance to find attractive yields. Says Axel: "Supranationals can represent a nice opportunity for investors who wouldn't normally look to Europe for investment options."