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Bonds

February 2012

The bond market continues to be dominated by eurozone sovereign debt and by politicians’ efforts to resolve the growing crisis. Government bonds in the UK, US and Germany continue to benefit from their “safe haven” status. Investors remain nervous of debt from the eurozone periphery, and yields remain close to historic lows. That said, they exhibited volatility during January, reacting to the ebbs and flows of investor risk appetite. Yields in all three markets ended the month slightly higher. The yield on ten-year Gilts was 2.06% at 31 January, with ten-year US Treasuries closing at 1.90% and German Bunds at 1.86%. In the middle of the month, Standard & Poor’s stripped France and Austria of their AAA credit ratings, but this news prompted little market reaction as it had already been factored into prices.

Italian and Spanish bonds appeared to retreat from the brink of default, thanks largely to European Central Bank intervention. Italian ten-year borrowing costs moved above 7% early in the month - a level commonly regarded as unsustainable - and equivalent-dated Spanish bonds touched 6%. But subsequently, the ECB intervened to prop up the ailing commercial banking sector with its long-term refinancing operation (LTRO). This involves lending money cheaply to Europe’s liquidity-strapped commercial banks. Much has been reinvested in short-dated peripheral bonds; during January, Spain had already financed around 20 per cent of its 2012 borrowing requirements. Confidence has grown, and ten-year yields in both Spain and Italy have fallen steadily, although they remain at elevated levels.

One blot on the horizon is Portugal. Its credit rating has now been downgraded to junk by all three major ratings agencies. Towards month-end, the yield on Portuguese ten-year debt briefly moved above 15%, raising fresh worries about the possibility of default.

The corporate bond market outperformed its government counterpart, with the yield spread between the two markets narrowing by an average of 20 basis points. A New Year rally was driven by a tidal wave of new issuance and a perception that corporate bond prices were overly depressed. The LTRO has effectively put a floor under the prices of financial sector corporate bond valuations, and banks have been using borrowed money to restructure their capital positions by buying back debt. Demand for non-financials was also robust, with particularly strong demand for longer-dated bonds issued by utilities companies.

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