Europe Nearing Zero Inflation Fuels 2-Year-Old Bond Rally

The euro area’s subdued inflation is giving investors another reason to lap up the region’s bonds while enabling governments to pay the lowest-ever rates to raise cash in capital markets.

While European Central Bank President Mario Draghi’s stimulus measures have suppressed yields across the continent, the rates investors can earn still beat those of similar-maturity U.S. Treasuries several times over when local inflation is stripped out. Spain’s 30-year bonds pay more than triple what Treasuries do in real terms. The nation, together with France, took advantage of that appetite again today selling bonds at record-low yields. Austria, Belgium and the Netherlands also had record low yields today on benchmark bonds.

“There is a large investor base for whom real yields are extremely important,” Craig Veysey, London-based head of fixed income at Sanlam Private Investments Ltd., whose parent company manages the equivalent of about $68 billion, said in a telephone interview yesterday. “For institutional investors that are buying bonds for the long term, real yields can look very attractive in certain parts of the periphery.”

The gains coincided with a report today showing euro-region consumer prices rose an annual 0.5 percent in June, stuck at the lowest rate since 2009.

Europe’s bonds have been rallying since July 2012, when Draghi pledged to do whatever it takes to safeguard the region after a selloff that threatened to splinter Europe’s monetary union. While the ECB is now grappling with the risk of deflation, the stimulus measures it introduced last month to counter that threat are boosting bonds at the same time as the subdued price growth preserves the value of the fixed payments on the securities.

Real Yields

The gains have pushed borrowing costs to record lows across the region, aiding governments that are trying to control their deficits. Spain sold three-year notes at an all-time low yield of 0.692 percent today, and France sold two-, four-, and five-year debt at the lowest yield on record.

Although Spain’s 10-year yields slipped last month below those of the U.S. for the first time since April 2010, the picture is different when the nation’s inflation rate of zero percent is taken into account. At 2.62 percent as of 4:10 p.m. London time today, the real yield is 2.22 percentage points more than what an investor could get holding Treasuries with a similar maturity. For 30-year debt, the rate in Spain is almost 4 percent, versus about 1.2 percent for Treasuries.

“You can safely say that in the medium to longer term inflation will be lower in the periphery and than in the core countries,” Elwin de Groot, a markets economist at Rabobank in Utrecht, the Netherlands, said in a telephone interview. “That could be another reason for seeing some value in those bonds.”

Price Volatility

European bond markets were roiled last week, reviving memories of the volatility seen during the region’s sovereign debt crisis, after a parent company of Portugal’s second-biggest lender missed some payments on commercial paper. Yields jumped briefly across the region as investors questioned whether rates from Greece to Spain had fallen too much and Germany’s 10-year rate tumbled below 1.20 percent.

The German yield was at 1.17 percent today, the lowest since May 2013, while Austrian, Belgian, Dutch and French yields dropped to records.

“Although price volatility on longer maturity bonds is much higher, investors are likely to be tempted further along the yield curve,” Guy Skinner, an investment director for fixed income at Aberdeen Asset Management in Edinburgh, said on July 10. “Although the level of yields and yield spreads in peripheral markets have fallen or tightened dramatically in the last three years, spreads are still substantially wider than they have been” since the formation of the euro in 1999, he said.

Portuguese Spread

Aberdeen Asset Management, Scotland’s biggest money manager, oversees about 325 billion pounds ($556 billion) after it bought Scottish Widows Investment Partnership in April. A yield curve is a chart showing rates on bonds of different maturities.

If the banking woes in Portugal evoked memories of the euro-region’s debt crisis, the minimal increase in periphery bond yields shows how far the nations have come in two years.

Although the yield difference, or spread, between Portuguese 10-year bonds and German bunds, widened 34 basis points to 2.66 percentage points last week, it has since contracted to 2.51 percentage points. That compares with more than 16 percentage points in 2012 and an average of 5.56 percentage points since the end of 2009.

“We still like the periphery, but is there still a lot of money to be made there? Of course not,” William de Vijlder, who oversees the equivalent of about $666 billion as Brussels-based chief investment officer at BNP Paribas SA, said in an July 14 interview at Bloomberg LP’s European headquarters in London. “But would you really want to buy bunds at 1.20?”

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