Danger in Safety? The Risks in Core Europe's Bonds
After a heavy bout of stock market pessimism and a long term rally in the bond markets, analysts say that the new year could spell danger for sovereign bonds in Europe's core and a shift back to equities could be on the cards.
Core sovereign bonds have rallied in recent years, leading to record low yields for both German bunds and U.K. gilts. This has caused yield curves to bull-flatten to very low levels in a similar manner to the curve of Japanese government bond yields in the 1990s.
But change is on the horizon, according to analysts.
"Market pessimism and the 'Japan trade' may have gone too far, particularly as some of the buying of core debt has been due to safe-haven flows," Peter Chatwell, fixed-income strategist at Credit Agricole told CNBC.com.
The spread between bond yields in the periphery and in the core in Europe will tighten in 2013, according to Chatwell, who says he feels uncomfortable taking on what he describes as "duration risk" with the longer 10-year benchmark bonds from countries such as Germany.
"I feel more comfortable taking some Italian risk or some Portuguese risk at the front end [short term], to find yield that way, rather than going out 10-years and taking what I think is now quite a gamble on policy rates over the long term," he said.
(Read More: This Could Be the Year Bonds Start to Deflate)
Yields for 10-year gilts fell below 1.5 percent in July and August, the lowest level seen since Bank of England records began in 1703. But on Wednesday the yield climbed back upwards through 2 percent, a level not seen since May 2012.
"I don't think there is a risk this year that investors will go away but I wouldn't put it in my top asset class, as well as bunds. In Europe I would rather have something a little more risky like peripheral banks or high-yield this year," Alberto Gallo senior credit strategist at at RBS told CNBC Thursday.
And the loss of confidence in the "Japan trade" and stock market optimism are not the only dangers apparent in the bond market. Analysts cite a potential rise in interest rates by the European Central Bank and the Federal Reserve, albeit not a sudden spike, as the underlying cause for caution.
The markets need only a "whiff" of a Fed reversal of interest rate policy to begin a temporary "dash for trash," say analysts at Blackrock, referring to highly leveraged growth stocks. That could lead to investors emptying some of the vast store of money in cash and low-yielding fixed income assets and opting for equities.
"Casualties would be 'safe' assets such as government bonds of the U.S., U.K., Germany and other euro zone core countries," it said.
"It takes just a minuscule rise in yield to trigger sizable bond price losses. There is a danger in safety, especially because most investors are positioned for rates to be low for long."
Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch predicts 2013 will be an "inflection year."
"The heyday of total returns is over: The era of equity-like returns in fixed income has come to an end," he said in a research note.
(Read More: When Will the Bond Bubble Burst?)
Credit Agricole's Chatwell remains unconvinced that 2013 will see a seismic shift to equities from bonds and safe havens could still be needed in the short term..
"Yields in core markets, in Germany for example, could be under some pressure to trade more sideways and then to start moving higher later on, but we've still got to get past a lot of uncertainty," he said.
—By CNBC's Matt Clinch