Bloomberg News

German Bunds Beaten by Spain Means Yields Above Treasuries

February 11, 2013

Bunds Beaten by Spain Means Yields Above Treasuries to JPMorgan

A streetlight stands and frames the European Central Bank headquarters in Frankfurt. With confidence recovering from last year’s debt crisis, German two-year note yields climbed to a 10-month high in January from below zero, while relative borrowing costs tumbled in Italy and Spain. Photographer: Ralph Orlowski/Bloomberg

Germany is losing a yearlong borrowing-cost advantage over the U.S. as healing in the 17- nation euro area lures investors to greater returns in Italian and Spanish bonds.

German securities had their worst January since at least 1986 and options traders hold almost three times more bets on further declines than a rally, according to data compiled by Bloomberg. That contrasts with Treasuries, where wagers through derivatives are about even. JPMorgan Chase & Co. says Germany’s 10-year yields will exceed U.S. rates for the first time since February 2012 by the end of the third quarter.

Demand for the euro area’s benchmark assets is waning after European Central Bank President Mario Draghi dispelled concern the bloc may break up and as banks pay back emergency loans two years earlier than required. With confidence recovering from last year’s debt crisis, German two-year note yields climbed to a 10-month high in January from below zero, while relative borrowing costs tumbled in Italy and Spain, the region’s third- and fourth-largest economies.

“Bunds could come under pressure as we expect to see more diversification into higher-yielding peripheral bonds,” said Oliver Eichmann, a money manager at DWS Investment GmbH in Frankfurt, Germany’s biggest mutual fund, which oversees $379 billion. “We prefer Treasuries in the near term.”

Draghi allayed investors’ concern the euro region would collapse after he pledged in July to do “whatever it takes” to hold the currency bloc together. The Stoxx Europe 600 Index of equities has rallied 12 percent since then and a composite gauge of euro-area services and manufacturing output improved to 48.6 in January, the highest level since March.

Crisis Remedies

After taking over the ECB from Jean-Claude Trichet on Nov. 1, 2011, Draghi introduced remedies to the debt crisis that erupted in Greece about three years ago including interest-rate cuts, an injection of 1 trillion euros ($1.34 trillion) into banks and an offer to buy government bonds.

Investors who believed Draghi’s July pledge earned 13 percent on Italian bonds, including 1.5 percent in January, according to a Bank of America Merrill Lynch index. Two-year note yields dropped as low as 1.275 percent on Jan. 10, just above the record 1.273 percent, according to data compiled by Bloomberg going back to 1993.

Italy’s notes yielded 150 basis points, or 1.50 percentage points, more than German two-year securities as of 12:56 p.m. in London. That’s down from 720 basis points more near the end of 2011.

Spain’s bonds returned 1.7 percent last month. The two-year yield gap with German debt has narrowed to 257 basis points from as much as 671 in July.

Yield Spread

While German Chancellor Angela Merkel endorsed Draghi’s plan, the gains in so-called peripheral-market debt came partly at the expense of her own securities, which slumped 1.8 percent in January. Treasuries lost 0.95 percent last month.

German two-year yields have surpassed equivalent rates in Japan and narrowed the gap with similar-maturity U.S. debt to the smallest in about a year. They’ve risen 28 basis points since July to 0.19 percent, while the yield on U.S. notes increased just four basis points, and German rates temporarily climbed above Treasuries last month. Japan’s two-year note yield fell to a record 0.023 percent on Feb. 7.

Germany sold 3.39 billion euros of six-month bills today at a yield of 0.02 percent, the first positive yield for the securities since June.

Europe’s smaller, less-traded and more-troubled economies handed investors even greater returns. Irish, Greek and Portuguese bonds rose 2.4 percent, 22 percent and 3.2 percent, respectively, in January, according to the Bank of America Merrill Lynch indexes.

Italian Appeal

Investors who sold bunds and used the money to buy Spanish or Italian bonds after Draghi signaled on Aug. 2 he would backstop troubled countries’ debt earned more than 16 percent through Jan. 31, the bond indexes show.

“We are dipping our toes in selective European credits, such as Italy,” Jonathan Lemco, a senior sovereign-debt analyst at Vanguard Group Inc., the largest provider of U.S. bond funds, said by phone from Valley Forge, Pennsylvania, on Feb. 5. “The European currency union will hold together for the foreseeable future.”

The difference in yield between 10-year bunds and Treasuries has narrowed to 34 basis points from 44 basis points in December. Bund yields were last above their U.S. counterparts in February 2012. In the past five years, the German securities have traded with a yield discount of as much as 90 basis points to Treasuries, and have yielded as much as 90 basis points more.

The gap was little changed last week as German and U.S. securities jumped amid political unrest before Italian elections later this month.

JPMorgan Estimates

JPMorgan forecasts the rate on German bonds will rise to 1.85 percent by the end of the third quarter, from 1.61 percent on Feb. 8, while the yield on similar-maturity Treasuries will drop to 1.80 percent, from 1.95 percent last week.

Investors buying German bunds at the current yield would lose 1.7 percent if they reached the level forecast by JPMorgan, data compiled by Bloomberg show. A similar investment on 10-year Treasuries would gain 4 percent.

“The balance of risk is shifting more toward the U.S. from Europe,” Pavan Wadhwa, the head of U.S. dollar rates strategy at JPMorgan in New York, said in a telephone interview Feb. 1. “Europe is in the process of stabilizing. Bunds will sell off relative to Treasuries.”

The ratio of options granting the right to sell the 10-year bund futures contract for June 2013 relative to those conferring the right to buy it was at 2.77 on Jan. 31, data compiled by Bloomberg show. For Treasuries, the balance was 1.09.

Economic Outlook

While the median of 52 economist estimates compiled by Bloomberg is for the euro-region to contract 0.1 percent in 2013, retreating for a second year, the outlook is improving faster than analysts predicted. Data are beating projections by the most since January 2011, according to the Citigroup Economic Surprise Index.

The services industry in Germany, Europe’s biggest economy, expanded last month at the fastest pace since June 2011. While Spain remains mired in recession, economic sentiment increased for a fifth month in January. Italian industrial production rose in December after falling for three consecutive months.

The extra yield that investors get for holding 10-year Italian bonds instead of German bunds narrowed to 243 basis points on Jan. 25, from 546 on July 25.

Berlusconi, Rajoy

Since then, the difference expanded to 298 basis points, after former premier Silvio Berlusconi narrowed the lead of front-runner Pier Luigi Bersani before an election on Feb. 24-25. Berlusconi has said he’ll roll back current Prime Minister Mario Monti’s austerity policies.

Spain’s yield spread narrowed to 379 basis points today from a high of 650 last year. The spread widened from as little as 324 basis points last month after Spanish Prime Minister Mariano Rajoy faced calls to resign from the opposition following newspaper reports said he accepted illegal cash payments. He said the allegations were unfounded.

German 10-year yields will increase to 1.96 percent by the end of this year, according to the average of 28 forecasters compiled by Bloomberg. Ten-year Treasury yields will rise to 2.27 percent, separate estimates show. In the U.S., the Federal Reserve is buying debt at the rate of $85 billion a month to spur growth.

Inflation Prospects

“We prefer bunds as our outlook for the European economy is not terribly positive,” said Michael Siviter, a London-based money manager at Invesco Ltd., which oversees $683 billion. “The fact that the Fed is willing to pursue more aggressive policy means that inflation is more likely, whereas Europe is almost pursuing a deflationary policy, which should mean bond yields stay relatively low.”

Inflation expectations as measured by the yield difference between 10-year Treasuries and their index-linked counterparts were at 2.54 percentage points today, while a similar gauge in Germany was at 1.92 percentage points.

Draghi’s measures risk proving too successful, either by encouraging complacency among lawmakers, or by raising borrowing costs and driving up the currency. He said on Feb. 7 that the euro’s appreciation risked damping inflation, a comment the market took to mean that further interest-rate cuts remained a possibility. The common currency weakened that day as yields on two-year German notes declined four basis points.

Financial institutions in the region are handing back emergency loans from the ECB two years earlier than required, a sign of growing confidence. Banks in the euro area said on Feb. 8 they planned to repay a further 5 billion euros, after giving back 137.1 billion euros at the first opportunity and 3.5 billion euros the following week.

“The world is not going to implode,” said Richard Schlanger, who helps invest $20 billion in fixed-income securities as vice president at Pioneer Investments in Boston. “The euro is going to survive.”

To contact the reporters on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net; Susanne Walker in New York at swalker33@bloomberg.net

To contact the editor responsible for this story: Paul Dobson at pdobson2@bloomberg.net


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