Thursday, 28 June 2012

The bond yields in Mallorca don’t feel like what they oughta…..

The £100 billion earmarked for Spanish banks was supposed to relieve some of the pressure on European capital markets, but do not – at least so far – seem to have had the desired effect.  Instead, because of the way in which the deal was structured, this sum becomes a liability of the Spanish government, putting further pressure on their creditworthiness.  This, in turn, has increased fears amongst bond holders that they will find themselves subordinated to the various EU institutions who might demand priority in any wider restructuring. This was the situation that lenders to Greece found themselves in – and, indeed, may find themselves in again - where they lost more than 70 per cent of their investments, while the ECB and other official lenders were exempt from the discounts.  The net result has seen Spanish bond yields soar to around 7%, within a whisker of Irish Bond yields with a similar maturity.  Elsewhere in the “single” currency, Germany’s cost for borrowing money for 10 years is just 1.51%.  How the ECB square this particular circle is of keen interest to us all, as has been highlighted by the tensions at the G20 summit.  Clearly, though, something will have to give as, to all intents and purposes, Spain is finding itself shut out of international capital markets.  The forthcoming summit of European leaders will, undoubtedly, have this on their agenda, but may find that markets will force it somewhat higher up the running order than they may like.

Source: Brewin Dolphin/DataStream
Where does this leave the UK?  Well, in Ireland bailing out its banking system saw its Government Debt to GDP ratio soar from 25% in 2007 to a peak of about 120%.  The rating agency Fitch, estimates that Spain’s peak will be 95% as it cut its rating to BBB from A.  In the UK Govt Debt as a percentage of GDP is 85.7% (according to Bloomberg) and is expected to peak – according to the Office for Budget Responsibility – at 92.7% in 2014/15.  Why, then, do ten year UK Government bonds yield 1.62%?  The answer is a little bit of this and a little bit of that.  “This” - in this context - is the quantitative easing programme instituted by the Bank of England and likely to be extended unless the economy shows more signs of recovery in the next few months.  “That” is – rightly or wrongly – a perceived safe haven status.  In the end, we have control of our own destiny in the way that Spain simply does not.

The diminishing returns on Government Bonds and, by association, other parts of the bond market have left investors in a difficult position.  In real, “inflation adjusted” terms, investors are not seeing a positive return, although it is a return a little better than the official bank rate of 0.5%. However, for investors looking to reduce some of the risk and volatility of their portfolio of investments, it can provide some vital “ballast” and is worthy, on that basis, of consideration.  Nevertheless, it seems unlikely in the extreme that bond market investors – at least in UK Government Bonds - will see the kind of returns over the next 15 years that they have seen over the last.

As for Europe, let us hope that the European Central Bank can refresh the bond yields that other Central Banks can’t reach.

Rob Burgeman
Divisional Director

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