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May sell-off too fresh for Bund yields to fall far -investors
October 20, 2015 / 10:29 AM / 2 years ago

May sell-off too fresh for Bund yields to fall far -investors

* Bund yields rangebound even as stock markets pummelled

* Memory of May Bund sell-off keeps investors sidelined

* Little value seen in Bunds below recent 0.50-0.65 percent range

* Reluctance to push down yields raises questions over ECB QE

By Marius Zaharia

LONDON, Oct 20 (Reuters) - Beware the promise of zero yields.

Financial markets are not renowned for learning from past mistakes, but as expectations of more European Central Bank stimulus grow, that is the lesson investors in German Bunds seem to have grasped from March’s first round.

Bund yields have held comfortably in a 0.50-0.65 percent range over the last two months even while weak global economic data sent German stocks about 15 percent lower. Normally, yields would have fallen sharply as investors sought shelter in an asset seen as among the safest in the world.

But the memory of a sell-off in May that took yields from near zero to above 1 percent is fresh and painful. And this reluctance to push long-term rates lower raises questions over how effective any extension of the ECB’s bond buying would be.

When 10-year German yields hit a record low 0.05 percent in April, most in the market were betting they would turn negative, encouraging investors to sell them on to the ECB, which had just started buying bonds in an effort to boost inflation.

But when a tiny uptick in price growth surprised the market, some investors took profits. An initial minor rise in yields snowballed into a concerted sell-off as the coupons on the bonds were insufficient to compensate for the loss in face value.

Back in May, many investors suffered double-digit percent capital losses on their Bund investments.

“(Investors) have in the back of their mind what happened in April and May,” said Grant Peterkin, manager of an absolute return bond fund at Lombard Odier. “It’s not just a function of what you think (ECB President Mario) Draghi is going to do or what the economy is going to do.”

Peterkin remains sidelined and, based on the trading he sees in the market, thinks other investors are keeping Bund positions to the minimum as well.


Trying to better understand what fair value for Bunds is, bond analysts at Swedish bank SEB applied to the German market a model developed by the New York Federal Reserve that breaks the yield on U.S. Treasuries into two components.

One is the market’s expectation of official central bank interest rates for the next 10 years. SEB analysts say that for Bunds this has been worth 0.3-0.5 percent in recent years.

The other is the term premium, or the premium that investors demand for holding an asset to maturity. This, the analysts say, stands at 0.3 percent. When 10-year yields were zero, it was minus 0.5 percent.

“A negative term premium basically means that the market doesn’t see any fundamental value in the Bund. The only reason to hold it with a negative term premium is that you expect to sell it tomorrow at a profit,” said Jussi Hiljanen, head of fixed income research at SEB.

“As soon as you lose the confidence that the yield continues to decline what you have is an instrument with no fundamental value at all. That generates a skyrocketing in yield when people sell. The market would be very hesitant to push the term premium below zero again.”

Although his base scenario is a 0.5 to 1 percent range for the coming months, Hiljanen says Bund yields could still fall to 0.25-0.30 percent due to the subdued global growth and inflation outlook coupled with the possibility of more ECB stimulus.

Such a scenario is not that enticing for bond buyers. A further fall in yields could earn investors a couple of extra basis points. A rise, on the other hand, brings the risk of a significant capital loss.

“The risk metrics of German Bunds are skewed ... The prospect of seeing it at 30-40 bps is not that attractive,” said Chris Wightman, Senior Portfolio Manager at Wells Fargo Asset Management. (Editing by Nigel Stephenson and Catherine Evans)

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