European Bond Yields Diverge

In a recent article in the FT (27 February, 2008) Joanna Chung outlined a very interesting story that has been developing in the European Bond Markets in the last few weeks. When the euro was introduced in the late 1990s the yields on Government Bonds right across the whole eurozone saw a very rapid convergence. In simple terms this means that they all fell to the level of the lowest yield that existed at this time. This meant that the yields on offer from the traditionally much more risky countries like Spain and Greece were virtually the same as those on offer from the much safer countries like Germany and France. The view was that if the bonds were now issued in the same currency they should enjoy the same level of risk and therefore identical yields. The yield differential between Italian and German Government bonds which had been as high as 600 basis points fell back to just a few basis points.

This is now changing in the wake of the worldwide credit crisis that has caused investors to become more reluctant to take on any unnecessary risk. So they now put a premium on buying German Government bonds rather than the more risky options available in the Greek and Spanish markets.

As the FT reports;

“The risk premium of 10-year Italian government bonds has risen 12 basis points to 43 bp over comparable German bonds since the beginning of the year, while that of Greek government bonds rose by 14bp to 44.5bp over bunds”.

The article suggests that the search for better credit risk only partly explains this development. The additional factor is the search for greater liquidity attached to certain eurozone Government bond markets. One attraction of the German Bund market is that it has a highly liquid futures contract attached to the market. This allows traders to utilise these instruments to manage their trading strategies. The FT article quotes Erik Wilders, head of Dutch State Treasury Agency, “Germany is the biggest and most liquid market, and that is what investors want right now”.