Kevin Adams, Director of Fixed Income and member of the Henderson Fixed Income Investment Strategy Group (ISG), considers the move down in sovereign bond yields, particularly in Germany where the 10-year bund yield hit a record low in early August.
Janus Henderson Investors
| 11.08.2014 09:25 Uhr
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The yield on the German 10-year bund has hit record lows, going below 1.04% in the first week of August. It is worth taking stock of that number. Investors in German sovereign debt are prepared to accept less than an 11% return for lending to the German government for 10 years. In contrast, UK gilts or US Treasuries of the same maturity are offering annual yields in the region of 2.4%.
So why is the German bund yield so low?
First, the economic outlook in the eurozone is more downbeat than elsewhere. Italy has technically re-entered recession and the European Central Bank (ECB) is so concerned about deflation that it enacted special measures in June, including negative interest rates on deposits that banks leave with the central bank. There is also an element of speculation about potential quantitative easing (QE) within bund prices. Should the ECB engage in QE, it is expected that German government debt would be a significant proportion of any asset purchases, should they be based on each country’s capital contribution – Germany is the eurozone’s biggest national population and economy and subscribes nearly 18% of the ECB’s capital.
With some commentators predicting outright deflation – a state of affairs in which money gains purchasing power because prices are declining – a positive return of 1.0% might seem sufficient compensation. A reference point might be Japan where the yield on the 10-year Japanese government bond is less than 0.6%, a symptom of ingrained low inflation/deflation. The chart below illustrates the decline in eurozone inflation in recent years, which is contributing to lower eurozone sovereign yields.
Declining inflation contributing to lower bund yields
Source: Datastream, 31 July 2002 to 31 July 2014, Eurozone CPI year-on-year % change, DS benchmark 10-year German government bond redemption yield.
Second, geopolitics and risk aversion are driving investors towards core bonds. The yields on US and UK government bonds, along with German and French bonds have been falling in recent weeks as investors worry about events in Ukraine and the Middle East. We are witnessing a standard flight to quality and, given that German bunds are viewed as the risk-free asset in Europe, this is also contributing to the downward pressure on yields.
Third, Germany is performing reasonably well economically. The fiscal budget is largely balanced and since Germany is not borrowing heavily, net additions of German debt are minimal. This creates scarcity value for the country’s debt as demand for safe German bunds from institutions such as pension funds exceeds the number of bonds being issued.
Can yields fall lower?
It is not impossible but yields at these levels feel rich. Only a Japan-style period of deflation would justify bund yields at these levels to a long-term investor. However, in the absence of a catalyst to alter sentiment (such as further moves towards higher interest rates in the US) and while the demand for bunds outstrips the supply, yields could remain at low levels for a while longer.
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