AXA IM highlights European bonds

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Chris Iggo, CIO Fixed Income at AXA Investment Managers, analyses trends on European bonds markets.

Zero bound?

As far as I know, there has not been a bond issued with a fixed rate negative coupon. Imagine if there was. Investors would be asked to invest in the bond at issue and then make a semi-annual payment to the issuer.

If governments were to do this is would mean that investors would not only be lending to the government but would pay a tax for the right to do so. This is different to buying secondary market bonds with negative yields to maturity.

In that case the money has already been lent to the borrower. An investor buying the bonds in the market would be doing so in the knowledge that if the bond is held until it matures the value of the cash-flows they receive will be less than the price paid for the bond. But there is no direct benefit to the issuer as it will have issued the bond at par and will redeem it at par (in most cases).

Of course, in the case of governments, the indirect benefit to them of market yields going negative is that when they do issue new bonds they can do so at increasingly lower coupons. But not negative. There is a zero bound. The world would need to be really ugly if investors were willing to pay a tax or fee to an issuer over the life of a bond for the right to have that issuer use their money. It would also be an interesting world for credit.

The compensation for paying a tax on an investment (that would mean a negative return) is that it would have to be the most solid of solid credits – AAA government risk. If the mind-set of the investor would be to accept that contract then what compensation would be needed to induce the investor to buy a corporate bond where there was credit risk? If the world was so uncertain that investors would be willing to buy negative coupon government bonds then surely corporate bond yields would need to be extremely high.

Cheap borrowing

In practice governments issue zero coupon bonds or bonds with a nominal coupon of, say, 0.125%. They might even combine a zero coupon with an issue price above par, so effectively locking in a loss to a buy and hold investor. The German finance ministry has issued a number of 2-year and 5-year bonds with zero coupons which now have negative market yields. If you buy these bonds at issue and hold them to maturity you will lose a little money and in real terms you will lose if inflation is positive over the period of investment.

Given the way the market is going ahead of the European Central Bank’s QE, more and more of the German curve could be generating a negative yield to maturity. The lowest coupon on a 10-year Bund is 0.5% for the one issued in January of this year and set to mature in February 2015 but it might not be too long before Germany is able to borrow interest free for 10-years.

France issued a 0.5% coupon 10-year bond in January and Holland issued a 0.25% coupon bond maturing in 2020 last August. Core European governments can basically borrow for nothing today. Will the same ever be seen in the periphery? It’s difficult to see how that could be justified given the lower credit rating and weaker economies of Southern Europe. Yet we do have a 0.5% coupon 2017 Spanish government bond and a 0.75% coupon 2018 Italian government bond.

Peripheral government bond yields have moved much lower since the ECB announced QE and there is a strong feeling in the market that yields could go even lower. Spain now trades less than 1% above German Bunds at the 10-year maturity with Italy just above 1% higher than Germany and Ireland at just 60 basis points above Bunds.

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