German debt returns dwindle as investors seek safety

LONDON Tue May 15, 2012 12:07pm EDT

LONDON (Reuters) - Investors in German bonds may soon get back less than they paid for the debt as they forego any profit and instead seek shelter from the euro zone's storm, driving borrowing costs for the region's safest issuer to unprecedented lows.

German bonds are already offering next to no return after a political crisis in Greece and bad debts plaguing Spanish banks, added to concern about global economic growth, prompted the flight into government debt regarded as a safe haven.

Borrowing costs for Germany, Britain, the United States and Japan have also tumbled to record lows at recent bond sales with the lack of a solution to the debt crisis keeping investors desperate to preserve their funds despite the dwindling returns.

"I don't think the disincentive from low yields will be enough to counteract the incentive for the safe haven status of a core market such as Germany," said Jack Kelly, fixed income investment director at Standard Life investments, which has about $243 billion of assets under management.

"Two year (German yields) could trade through zero. They're ultimately reflective of the flight to quality and 10-year Bund yields could get to sub 1 percent," he said.

Two year German bonds are yielding as little as six basis points and a fall below zero, as is already the case for some short-term Treasury bills, means investors would pay more to buy the debt than they would get back.

Investors can buy German bonds directly from the state in auctions or from their peers on the secondary market. Hunger for the debt has pushed prices above face value: for instance, an investor has to pay about 100.34 euros for every 100 euros' worth of two-year debt in the secondary market.

As the price continues to rise, this will also swallow up the meager interest paid on the bonds, meaning investors are effectively paying the German state to look after their money.

On top of that, the value of the bonds is also being eroded by inflation, giving a very poor deal to investors worried about the turmoil on the euro zone's periphery and a possible Greek exit from the common currency.

Benchmark German 10-year yields have tumbled to all-time lows around 1.43 percent.

"We expect the periphery crisis to take a turn for the worse with Greek exit risks seen as a driver. We still expect negative two-year (German) Schatz yields. Stay long Bunds," said Harvinder Sian, a strategist Royal Bank of Scotland.

JAPAN-STYLE RISKS

The depressed returns have prompted comparisons with Japan, where 10-year yields have averaged just 1.4 percent since 2000, the end of a decade that followed the bursting of a property bubble.

Although many European officials and some strategists say such comparisons are unwarranted, the Dutch central bank warned last week that Europe was at risk of such a Japanese-style "Lost Decade" of low economic growth, weak consumer spending, poor company investment and tougher borrowing conditions.

German yields have tumbled across all maturities, with the 30-year bond offering a record low 2.12 percent - almost one percentage point less than it cost Spain to issue one-year debt this week. With German inflation running at 2.1 percent, buying the bonds now would barely cover cost-of-living increases.

"German Bunds are not bought because of carry return, but as a safe haven. So yields may not have seen the bottom yet," said Christoph Kind, head of asset allocation at Frankfurt Trust, which manages assets worth 16 billion euro ($20.54 billion).

While the shrinking returns in German bonds are proving no deterrent to investors, investors are also to looking at top-rated markets outside Europe such as Australia and New Zealand, though the risk of currency fluctuations could limit flows into those markets.

Australian 10-year bonds, for example, are yielding 3.24 percent AU10YT=TWEB, almost two percentage points more than German counterparts.

"Australia and New Zealand have very attractive yield levels and pretty stable economies. Sweden and Norway may also offer alternatives for investors. But investors have to actively manage the currency risks involved to make them an additional source of return," Kind said. ($1 = 0.7789 euros)

(Graphic by Scott Barber; editing by David Stamp)

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