LONDON Jan 8 Peripheral euro zone bonds are
unlikely to reach the levels seen in the years before the global
financial and regional debt crises even though their rally may
have further to run.
Investors are starting to worry the market is not liquid
enough and credit ratings not high enough to extend the rise in
prices that started when the European Central Bank boss said in
July 2012 he would do whatever it took to protect the euro.
The rally for bonds of the euro zone's most indebted
countries continued last year, helped by reduced risk of a euro
breakup, ECB support to banks, low inflation and an improved
The start of 2014 has provided another boost as banks, which
loaded up on higher-rated bonds to boost their balance sheets
for a year-end snapshot before ECB stress tests later this year
switch back into riskier and higher-yielding debt.
Spain and Ireland, two of the countries worst hit by the
debt crisis, have rarely been able to borrow more cheaply. They
were emerging markets in the 1980s and 10-year yields before the
euro launched in 1999 were over 12 percent.
They fell after euro entry but soared at the height of the
debt crisis. Spain's 10-year yield reached a euro lifetime high
of 7.5 percent in the summer of 2012 but is currently 3.8
percent, not far from 2.95 percent for the United States.
"You could soon see Spain and U.S. Treasuries both at 3.5
percent. But there's a 7-notch ratings differential there - this
could change the structure of international demand for Spanish
debt," said Alessandro Tentori, global head of rates strategy at
Citigroup in London.
In the years immediately preceding the 2007-08 crisis these
spreads were virtually zero. In the mid-1990s Irish and Spanish
yields were even lower than Germany's.
But analysts say that is unlikely to happen again.
For much of the 2000-09 decade, Ireland and Spain were AAA
credits, according to Standard `& Poor's ratings. Now, Spain is
rated BBB- and Baa3 by S&P and Moody's, respectively. These are
the lowest possible investment grade ratings and nine notches
below AAA-rated Germany.
S&P and Fitch have Ireland at an investment grade rating of
BBB+ but that's still seven notches below Germany, while Moody's
has it at a "junk" rating of Ba1.
Many asset managers including pension funds and central
banks are mandated to invest only in high-level investment grade
bonds. At some point, they will decide higher yields offered by
peripheral bonds don't compensate the credit risk over 10 years.
The collapse in borrowing costs has been dramatic. Ireland's
10-year yield fell to 3.26 percent on Tuesday, the lowest in
eight years and only 136 basis points over benchmark German
Bunds as investors rushed to buy the country's new 10-year bond.
Ireland's yield spread over Germany was almost 1,200 basis
points in mid-2011. Spain's spread over bunds has shrunk by two
thirds since mid-2012 and is now under 200 basis points for the
first time in nearly three years.
But even though these bonds offer attractive returns,
liquidity is an issue for big investors such as pension funds,
insurance funds and central banks. They prefer to be in deep and
liquid markets in order to better protect their investments from
sharp price fluctuations.
The premium 10-year Spanish and Italian bonds offer
investors over U.S. Treasuries - the most liquid and generally
considered the safest investment in the world - is now less than
1 percentage point. The Irish premium is less than 50 basis
The more these spreads converge, the more likely it is
international investors will decide the ratings, liquidity and
credit risks make peripheral bonds unappealing.
"If you buy Treasuries, you know you can sell them again,"
said Ralf Preusser, head of EMEA rates strategy at Bank of
America-Merrill Lynch in London.
In addition, the euro zone is experiencing record low
inflation. While that helps keep official interest rates and
market yields low, it makes it difficult for countries to bring
their high debt down to sustainable levels over the long term.
Spain's outstanding debt is almost 900 billion euros, the
equivalent of 93 percent of the country's annual economic
output. The Irish and Portuguese bond markets are each only 143
billion euros in size but that is well over 120 percent of their
Italy's outstanding debt is a hefty 1.7 trillion euros,
about the same as Germany's. But Italy's debt load is the
highest in the developed world at 127 percent of economic output
and forecast to reach 130 percent this year.
Sluggish growth and low inflation makes it more difficult to
ease that burden.
"Debt sustainability is by no means assured. It makes a big
difference if nominal GDP growth is 2 percent or 3 percent,"