German bonds ripe for fall however crisis plays out

LONDON (Reuters) - A growing number of fund managers are questioning exactly how much protection German government bonds offer from the euro zone crisis, fearing a sudden plunge in value from the record high prices at which they trade.

Trading on a reputation for sound money built up over decades, bonds issued by the German government - known as Bunds - have become the ultimate refuge in Europe for investors looking to shield their cash from the worst ravages of the debt crisis.

Since Greece's inconclusive election on May 6 opened up the prospect of the country falling out of the euro zone - and potentially unleashing financial market chaos on a par with the Lehman bankruptcy - demand for German bonds has been unrelenting, driving the country's borrowing costs down to record lows almost on a daily basis.

But some investors say that if Greece does crash out of the euro and default on its debts, Germany will wind up bearing a heavy cost of cleaning up the mess - whether it be in writing off previous bailouts, propping up banks or taking more responsibility for other euro zone governments' debt.

"We'd rather not be in Bunds at these levels," said Luke Hickmore, an investment director who manages a 26 billion pounds credit fund and a 92 million pounds strategic bond fund for Scottish Widows IP.

"The wall of money trying to find a safe haven has ended up in Germany and may end up disappointed in how safe it actually is. Germany is on the hook for a lot of problems," he said.

While many investors are forced to hold German bonds in their portfolios as they track benchmark investments, a growing number think Bund's eye-watering rally is irrational.

They fear a sharp sell-off in German bonds might follow when Greece's crisis enters a new stage, regardless of whether the country leaves the euro. Some believe the cost for Germany to borrow for 10-years, an internationally comparable benchmark maturity, could even double from the record lows of 1.35 percent hit last week.

Hickmore at Scottish Widows said that if Greece stayed in the bloc, safe haven flows would reverse rapidly and German bonds would weaken. If it leaves, Germany would not escape the fallout given its exposure to the weakest euro zone countries.

He prefers UK and U.S. government bonds, which are paying historically low interest rates around 1.75 percent to borrow for 10-years as some investors steer clear of the euro zone entirely.

BURDEN SHARING

One of the reasons for international investors' increasing wariness of the high price tag on German bonds is the issue of whether the euro zone crisis will force Germany to overcome its fierce resistance to issuing common euro zone bonds while the crisis still rages.

If such a plan was adopted, Germany would no longer be able to borrow money based purely on its own credit worthiness, but would have to share its track record with less trusted euro zone neighbours, so they can overcome markets' reluctance to lend to them.

"Ultimately we feel that there will be some kind of cross-euro zone burden sharing and Germany being the richest in the European Union, and the biggest, will probably have to bear the price of that," said Sandra Holdsworth, investment manager at Kames Capital, who oversees assets of about 400 million pounds.

"Then (German bonds) wouldn't be a safe haven at all," Holdsworth said, adding she was more likely to reduce the proportion of German bonds in her portfolio in the future than increase it.

For the same reason, Michael Siviter, a portfolio manager for Invesco overseeing 160 million euros of assets, said he was cutting back his exposure to Bunds, instead picking up other perceived safe-haven bonds like those issued by the UK, Norwegian, Swedish and Danish governments, all of whom sit outside the euro zone.

Another solution to the crisis that some economists propose, also strongly opposed by Germany, is the ECB becoming the lender of last resort for Greece and possibly other countries, which would effectively mean printing money.

That would lead to higher German inflation and is one of the reasons Bryn Jones, who manages 120 million pounds as Rathbone's fixed income investment director, is "keeping away" from Bunds.

Many analysts believe that despite Germany's protestations that it will not countenance such measures, the history of the crisis shows that when market turbulence gets so destabilising that the whole euro project looks to be at risk, previously taboo policy areas are considered.

For instance when the European Central Bank began to buy government bonds to prop-up struggling governments, or issued a trillion euros worth of ultra-cheap loans to prevent a credit crunch.

"HORRIBLY EXPENSIVE"

Such a scenario has lead Jon Day, global fixed income fund manager at Newton Investment Management, which holds 6.1 billion pounds of fixed income assets, to also favour Dutch, Finnish, UK and U.S. debt over Bunds.

"In the markets' darkest point they will probably come in and do something (for the euro zone)," Day said.

If the tide does turn again German debt, the fall in prices could be quick and pronounced.

Traders say hedge funds placing short-term speculative bets have been increasingly active in Bund markets in recent weeks - a sign that Bund yields will be more volatile in the near-term.

"We think Bunds are horribly expensive, said Russell Silberston, who manages around $30 billion worth of fixed income assets as head of global interest rates for Investec AM, and has been selling Bunds in the past few weeks.

"The very interesting thing for Germany is that if we get some sort of solution (to the debt crisis) ... we can see a big sell-off. Interest rates in Germany should be near 3 percent."

(Editing by Toby Chopra)