Fixed IncomeMar 5 2012

Dealing with deflating yields

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ByNyree Stewart

Duration is a word that is cropping up more often when talking about fixed income, especially in such volatile times, but in areas such as Europe are short-dated bonds actually worth the bother?

From a government bond standpoint the results are not encouraging. Statistics from the European Central Bank (ECB) on the spot rate or yield of AAA-rated euro area central government bonds show the spot rate for one-year bonds is just 0.22 per cent as of February 17.

The figure is not much better for other short-term bonds, with two and three-year spot rates of 0.47 per cent and 0.81 per cent, respectively. The further along the curve you go – in other words, the longer until a bond matures – the better the returns you get. Ten-year bonds yield approximately 2.68 per cent, for instance.

Richard Carter, fixed income specialist at Quilter, points out the ECB’s announcement of the long-term refinancing operation (LTRO) at the end of last year has driven many of the short-dated yields down aggressively in the past couple of months.

“You could actually probably argue that some of the value has gone out of them at the moment. The Italian and Spanish short-dated bond yields in particular have come down massively. Italian government bond yields have come down by approximately 4 per cent since early December, so they are not as cheap as they possibly were back then.”

Mr Carter suggests investors are looking to use them as a potential alternative to cash, as they do not want to take massive bets on buying more unpredictable long-term bonds.

“But if you’re looking at Europe, you’ve got so many different risks over there, with a central Greek default and everything that’s going on,” he says. “So while you might think a two-year bond is very low risk you never quite know, particularly in Europe.”

Jack Kelly, manager of the Standard Life Euro All-Government and Global Bond Sicav funds, says bond yields have fallen in core European markets to extremely low levels. Expectations for monetary policy moves are anticipated to be lower and even on hold for some time.

“The LTRO has given domestic banks access to three-year funding, which enables them to buy sovereign debt. What’s interesting now is that peripheral government yields, in the front end at least, are now very low relative to where they were. Spanish government two-year yields are roughly 2.5 per cent and Italian two-year yields are some 3 per cent.