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BLBG: European Bonds Rise; Credit Crisis Spurs Demand for Safe Assets
By Lukanyo Mnyanda

Oct. 6 (Bloomberg) -- European bonds surged, sending the yield on the two-year note to the lowest level since March, as bailouts of banks including Fortis and sliding stock markets drove investors to the safest assets.

The difference in yield, or spread, between two- and 10- year German bonds widened to the most since February as investors favored shorter-dated maturities amid the spreading financial turmoil and increased bets on an interest-rate cut by the European Central Bank. BNP Paribas SA agreed to take control of Fortis in Belgium and Luxembourg. Stocks slid in Europe and Asia, and U.S. index futures dropped.

``The continued turbulence is driving yields lower and everyone is waiting for what's to come next,'' said Michael Markovic, a senior fixed-income strategist in Zurich at Credit Suisse Group, Switzerland's second-biggest bank. ``The likelihood for rate cuts has also increased.''

The yield on the two-year note tumbled as much as 24 basis points to 3.05 percent, the lowest level since March 19, and was at 3.08 percent as of 11:45 a.m. in London. The 4 percent note due September 2010 advanced 0.38 or 3.8 euros per 1,000-euro ($1,359) face amount, to 101.69.

The yield on the German 10-year bund, Europe's benchmark government security, slipped as much as 14 basis points and was at 3.79 percent. Yields move inversely to bond prices.

Investors should favor shorter-dated notes with maturities of up to five years, said Markovic, adding that the 10-year yield will probably reach 3.9 percent in 12 months.

European Leaders

Leaders from the four biggest European economies, meeting in Paris two days ago, stopped short of announcing a coordinated regional rescue package for banks. The U.S. on Oct. 3 signed into law a $700 billion program to remove tainted assets from bank balance sheets.

BNP Paribas will pay 9 billion euros in stock and 5.5 billion euros in cash for 75 percent of Fortis Bank Belgium, all of the Belgian insurance operations, and 67 percent of Fortis's bank in Luxembourg, the Paris-based bank said today. The German government and the country's banks and insurers agreed on a 50 billion-euro bailout package for commercial property lender Hypo Real Estate Holding AG after an earlier bailout faltered.

``This flurry of events confirms that the financial storm has moved to Europe in full force,'' Marco Annunziata, chief economist at Unicredit MIB in London, wrote in a client note. ``Market volatility is set to remain high this week.''

The Dow Jones Stoxx 600 Index, a European equity benchmark, lost 5.3 percent and the MSCI Asia Pacific Index slid 4.4 percent. Futures on the Standard & Poor's 500 Index fell 2.2 percent.

ECB Rates

Traders are betting the ECB will lower its main refinancing rate next month. The odds of a 25-basis-point cut are more than 100 percent, according to a Credit Suisse Group index of derivatives. The implied yield on the December Euribor futures contract dropped 18 basis points to 4.59 percent, the lowest level since May.

Government bonds rose last week after ECB President Jean- Claude Trichet said policy makers discussed reducing their key rate to buoy the 15-nation economy. HSBC Holdings Plc cut its forecast for euro-area growth next year to 0.4 percent, from 0.9 percent, economists led by Janet Henry in London wrote in a research note.

Investors are reducing their inflation expectations, according to bond yields. The difference in yield between the five-year French inflation-protected note and its regular counterpart fell 12 basis points today to 1.64 percentage points. The so-called breakeven rate has narrowed from a record 2.83 percentage points on July 3.

Yield Spread

Two-year German notes yielded 71 basis points less than 10- year bunds, the widest spread since Feb. 29. The shorter-dated securities, which are more sensitive to the interest-rate outlook, yielded 21 basis points more than bunds as recently as June 6.

European bonds outperformed U.S. Treasuries in the past three months, handing investors a 4.7 percent return, compared with 3.4 percent for their U.S. counterparts, according to Merrill Lynch & Co.'s EMU Direct Government and Treasury Master indexes.

The yield advantage of the two-year German government note over equivalent-maturity U.S. securities dropped 11 basis points to 161sre basis points today. The spread narrowed from 226 basis points in June, which was the most this year.

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net