Bond Watching

04/11/2013 at 5:57 pm

The latest Italian government bond auctions took place a few days ago. They were maxed out on low yields against high demand. In fact at a yield of 4.1% the Italian ten year is within sight of its spring low, and trading at around the levels seen before the Greek debacle began in 2010. Only two years ago it was looking as if the bond market might break Italy. How times change.

Looking further around the eurozone periphery there are some other points of note too. In Spain, which has not seen the same political upheaval as Italy has done of late, the ten year yield dipped below 4% on Friday – again, the lowest level since the Greek crisis started to unfold. In Greece itself, ten year paper currently yields 7.7%, down from 12% at the beginning of the year.

There is some truth in the argument that this reflects relief in the wake of the worst of the temper tantrum. It is also impossible to reject with complete certainty – as ever – the warnings that Europe could still collapse in a default hurricane, its pseudo-currency breaking into pieces round its feet, etc. Look around the rest of the global bond market, however, and it is possible we are seeing signs of something else.

Let’s start with the safe havens. Ten year US debt at 2.6% has come down from a taper tantrum high of 3%, but remains over 120bp above its 2012 low and is back within the range seen prior to the stock market crash of 2011. In Germany, by contrast, the market never sold off so much in the first place. The current ten year yield of 1.7% is about 30bp under where it got to in August but only 50bp off the bottom. It has quite some distance to go before reaching the range it saw in 2010.

In fact, if we look at the spread between the two markets over time, we see that it is normal for US yields to push much higher than German ones in times of recovery and to fall below them in periods of economic weakness and poor market sentiment. Growth and inflation are typically higher in the US, especially in the good times, and it is in the bad times that treasuries tend to have strongest investor appeal. In other words, the relationship between the two markets has been normalizing.

Turning to credit, the iTraxx Europe index stands at 84bp, meaning that on average an investment-grade 5-year corporate note should be expected to yield 84bp over LIBOR. In line with equity markets the Europe index has more than made up the ground lost in 2011, though it remains above the 50bp level seen at the end of 2007 and the 25-30bp area it was rooted to before the credit crunch earlier that year.

The equivalent high yield index, the iTraxx crossover, has followed equity more closely. Its spread of 345bp is in line with the end-’07 level and it is not far off the 200bp it averaged in the six months before the crunch. Not all high yield credit is equal, however. Emerging market sovereign spreads at about 330bp are still above the level seen prior to the 2011 crash and remain some distance away from 2007 territory.

Markets have certainly been nervous on occasion this year, and shown inconsistency in some respects. But what we have seen in bond world as elsewhere has been more generally a function of recovery and normalizing market conditions. It is arguably this “bigger picture” which allows us to judge whether episodes of volatility and incongruity present us with opportunities – and take advantage of them accordingly.


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