Diving bond yields mask investor ambivalence

LONDON: The desire to preserve the value of investments makes a powerful incentive at the best of times. These are not the best of times, so it is all the easier to understand the attraction of protection over profit. Fear still trumps greed in the minds of most investors.

Alarm about the state of the global economy, and the rising risk of deflation, let the German government sell 10-year bunds at super-punchy prices on Aug. 24. Anxiety about possible deflation in future is such that holders of these German bunds, in common with those holding many US treasuries and UK gilts, seem to be prepared to suffer actual deflation in the value of their debt investments now. Inflation is currently running higher than yields on many of these sovereign bonds.

The appetite for bunds -- and gilts and Treasuries -- is even more curious since many of the developed world's economic difficulties stem from sovereign indebtedness. In the circumstances investors would be expected to shun the assets, in the manner (if the not degree) they have shunned sovereign debts of peripheral euro zone states.

Parking money in questionable assets is not illogical -- if bigger questions hang over other asset classes. Equities are riskier in the sense that they come lower down creditor pecking orders. Besides, investors can switch out of fixed income if the deflation risk fades and economic growth, and inflation, hovers more clearly into view. But equities -- to judge by dividend yield statistics and price earnings ratios - look as cheap and bonds look expensive. Effective switching may have to be rapid. Timing risks won't disappear, either.

A closer look at the details of the German bund auction shows that investors are not quite as captivated by sovereign debt as the rock-bottom yields might suggest. The bund auction on Aug. 24 was only 1.4 times covered by offers. True, that is higher than July, but given the intervening ructions some increase is only to be expected.

More interestingly, the 1.4 figure compares with a 1.66 average cover for this year, according to Thomson Reuters data. Global investors might be still drawn to the apparent safety of higher quality sovereign bonds. But they are not falling over themselves to buy.

CONTEXT NEWS

The German government sold 4.86 billion euros of 10-year bunds with a coupon of 2.25 percent on Aug. 24, matching the lowest ever on this variety of German debt. The latest auction was covered 1.4 times, compared to an average of 1.66 times for similar sales this year, Thomson Reuters data show.

In the secondary market, the yield on the 10-year bunds has fallen as low as 2.1 percent in recent trades, but was at 2.2 percent on Aug. 25, leaving real interest rates - after factoring inflation into account, negative. Since 1981, yields on 10-year bunds have, on average, been 3.6 percent higher than the common measure of inflation.

Copyright Reuters, 2011