Investors are willing to own German bunds at zero yields on speculation the currency boost from a euro breakup would compensate for the sacrifice in returns.
“If you buy German assets denominated in euros today, you could find yourself holding an asset in a superior currency in a breakup scenario,” said Jamie Stuttard, who helps oversee $1.6 trillion as head of international bonds at Fidelity Management and Research Co. in London. “There isn’t a lot of value in German government bonds at these yield levels, and the single best reason to own German assets is re-denomination risk.”
The yield on German notes maturing in 2014 dropped below zero on June 1 and has been negative each day since July 6. While European leaders said they are working on a plan to help defuse the debt crisis, traders raised bets on euro disintegration. The implied probability of a country leaving the monetary union by the end of 2014 rose to 66 percent last week from 64 percent a week ago, according to bets on Intrade.com.
“The currency trade is the main driver of low yields, not only in Germany but also in Switzerland, France, Austria, the Netherlands and Belgium,” said Michael Markovic, a senior fixed-income strategist at Credit Suisse Group AG in Zurich. The debt problem of peripheral countries “is the strength of Germany, Austria and France. Without this weakness, the stronger countries would never pay such low yields.”
Belgium’s five-year borrowing cost of 1.31 percent is within 20 basis points of the record low reached July 20. Investors earn just 0.15 percent on French two-year notes and 0.5 percent on Dutch securities with similar maturities.
Yields for Austria, Belgium, Finland, France, Germany and the Netherlands have declined to records as investor demand for their debt increases. The euro traded at $1.2324 yesterday, or 50 percent above its record low of 82.30 U.S. cents reached in October 2000.
“There’s clearly an aspect of euro-breakup premiums being built into core euro-zone bond prices,” said Mark Dowding, a fixed-income portfolio manager at BlueBay Asset Management in London, which oversees $41 billion in assets. “Effectively you can say that if one believes that the euro is going to cease to exist, then the current low yields make sense.”
Spanish and Italian bond yields have fallen from euro-era highs in recent weeks on speculation the European Central Bank will resume buying bonds to curb borrowing costs. JPMorgan Chase & Co., the largest U.S. bank by assets, suggests investors should bet on further declines in Spanish bond values as a slumping economy hobbles the nation’s efforts to mend its finances. Spanish 10-year yields are 6.30 percent, down from 7.75 percent on July 25. The yield on 10-year Italian securities fell to 5.78 percent from a euro-era high of 7.48 percent reached on Nov. 9.
The central bank will decide at a September meeting whether to cap yields on euro sovereign debt by pledging unlimited bond purchases, Germany’s Spiegel Magazine reported without saying where it obtained the information. An ECB spokesman said yesterday the central bank has not discussed any plan to target bond yields.
“You could argue that a firewall is being put in place to make it potentially easier to keep the euro area together in case a member country such as Greece did leave,” said John Stopford, head of fixed income at Investec Asset Management. “We’re gradually moving toward an environment where there is some support mechanism for the periphery, but that would certainly be tested if a country left.”
This scenario could lead to a scaled-down euro currency to include Germany and possibly the so-called semi-core nations such as France, the Netherlands, Austria and Belgium, which investors perceive could appreciate in value if it traded without the large debt burdens of other troubled economies that currently make up the euro area.
Investors are paying more to protect against the cost of sovereign default on some euro area bonds than they receive in cash yields. For example, the cost of insuring against sovereign default for five years for Germany is 55 basis points, compared with a five-year cash yield of 43 basis points.
The cost of insuring against a sovereign default in France is 128 basis points, versus a five-year bond yield of 96 basis points. CDS premiums were also higher than the respective five- year yields in Belgium and Austria.
“The currency trade is visible if you compare the cash yields and CDS levels,” said Markovic at Credit Suisse. “You pay more in CDS than the cash yield is returning.” Investors, though, may abandon the currency appreciation trade once they realize the true price that Germany would pay to cover the cost of countries leaving the bloc, he said.
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