German Curve Reveals Woes Masked by Spanish Rally: Euro Credit

The widening yield gap between 10-and 30-year German government securities suggests recent gains in Spanish and Italian bonds may prove unsustainable.

The spread, a measure of risk perceptions among bondholders, rose to 97.5 basis points on April 4, the most since September 2011, as 10-year yields plunged. The steepening yield curve suggests investors are favoring Europe’s safest fixed-income assets as Italy awaits a government seven weeks after elections and the bank crisis in Cyprus stokes concern the region’s debt crisis may worsen.

While securities from Europe’s periphery have weathered haggling over aid for Cyprus, with Spanish 10-year borrowing costs down to the lowest since November 2010, German 10-year yields have declined to eight-month lows. The Cypriot plan came almost nine months after the nation first requested aid, Slovenia risks seeking a bailout, and a final agreement on a so-called financial union remains elusive.

“The German yield curve is driven primarily by risk aversion,” said Luca Cazzulani, a senior fixed-income strategist at UniCredit Global Research in Milan. “Despite some sign of stability in the euro-region’s bond market, there’s a lot of uncertainty. People are still looking for the safest assets to preserve their capital. Ten-year German debt is a popular choice.”

‘Very Cautious’

Daiwa SB Investments Ltd., which manages the equivalent of about $51 billion, is “still very cautious” about peripheral bonds, according to Kei Katayama, who buys non-yen debt for Japan’s second-largest brokerage.

“The problem in the region is more political than financial, and there are too many conflicts and too many members involved,” said Katayama. “It’s hard to see how they are going to reach solutions that are effective and logical. There is always the possibility that an agreement on a difficult problem is reached because of political reasons. That sort of situation is uncomfortable for money managers like myself who are not familiar with this kind of political analysis.”

Ten-year German bonds yield about 1.27 percent today, after touching 1.20 percent on April 5, the lowest since July 24. The rate on 30-year debt is 2.21 percent, leaving the yield difference between the securities 94 basis points, up from an average of 74 in 2012.

Cazzulani said investors prefer 10-year bonds to two-year notes or 30-year debt as they offer higher yields than the former and are less vulnerable to inflation than the latter.

German two-year note yields are at 0.02 percent, and may fall further, as European Central Bank President Mario Draghi signalled on April 4 that policy makers stand ready to cut borrowing costs if the economy deteriorates. The ECB’s maintenance of record low interest rate during an extended period risks fuelling inflation in a longer-term, making holding 30-year debt less attractive.

Japanese Demand

The spread may narrow in coming months, according to strategists at HSBC Holdings Plc in London. They suggest a flattening trend driven by anticipation that Japanese investors, buoyed by the Bank of Japan’s unprecedented stimulus plan, will seek longer-dated bonds for higher returns.

“The weakness of the economy, falling inflation, and low probability of the ECB starting its own quantitative easing means German and French bonds could be regarded as good substitutes for Japanese government bonds,” Steven Major, HSBC’s head of global fixed-income research, wrote in a client note on April 11. “But as the yields of 10-year benchmarks fall, there will be a natural tendency to look for the next target.”

The BOJ said April 4 that it plans to buy 7.5 trillion yen ($75.8 billion) of bonds a month, the biggest such move since the nation began a quantitative easing program in 2001 to boost its economy.

Spanish Yields

Bonds from the so-called peripheral nations rallied from July through January after Draghi pledged to backstop the euro, luring investors back to the higher-yielding European assets that they abandoned during the debt crisis. Draghi proposed a program known as Outright Monetary Transactions, under which the ECB will buy the bonds of member nations that request assistance and meet certain criteria.

The yield on Spanish 10-year bonds dropped to 4.61 percent on April 11 from 5.27 percent at the end of last year. Italian 10-year yields fell 45 basis points this month.

Italy remains without a new government after an election in February failed to produce a parliamentary majority, leaving Prime Minister Mario Monti as caretaker. Monti said April 10 that Italy’s debt will reach a post-war record of 130.4 percent of gross domestic product this year as the euro region’s third-biggest economy borrows to help contribute to bailouts and pay arrears to government suppliers.

Slovenia’s Woes

The European Commission warned April 10 that Slovenian banks may need fresh capital as over-indebted companies struggle to repay loans amid a double-dip recession. Shrinking demand at last week’s debt auction signaled that investors increasingly expect Slovenia to seek a bailout. Spain is already tapping aid for its banking system.

German bonds were further supported this month as reports indicated the euro economy is struggling to emerge from recession.

An index of services activity based on a survey of purchasing managers declined to 46.4 last month from 47.9 in February, London-based Markit Economics said April 4. A similar report for the manufacturing industry, released on April 2, showed a reading of 46.8, below the 50-level which indicates the border between expansion and contraction for a 20th month.

Draghi signaled this month that further stimulus is possible and that monetary policy will “remain accommodative for as long as needed.”

The steepening curve is “mostly down to risk aversion,” said Allan von Mehren, chief analyst at Danske Bank A/S in Copenhagen. “Data has really disappointed and the ECB may be back at the table. I think we’re in a more traditional pattern when yields come down we see a steepening of the curve.”

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