Report on the European Bond Market †November 2010 to April 2012 Free Essays

This report describes the performance of the European bond market for the last 18 months and evaluates the impact of the major events, causes and factors which affected the sovereign and corporate bond market during this period. The report also provides the future of the European bond market based on the political scenario prevailing in that region along with a discussion on the methods to ease the financial crisis in the Euro zone. Introduction The European bond market experienced severe tension in the year of 2011 and the sovereign yields increased further. We will write a custom essay sample on Report on the European Bond Market – November 2010 to April 2012 or any similar topic only for you Order Now Wealth holders are aware of the risk and price the bonds accordingly. In some cases there is an overestimation of risk which leads to an increase of the respective yield (see Appendix 1.1) (European Central Bank, 2012). European Bond Market Performance Performance of Sovereign Bond The risk involved in the European bond market intensified considerably over the past 18 months due to slowing global growth prospect and broadening of concern about the government debt position in large European economies. Chart 1 shows the yield spreads (Appendix 1.2) of selected European countries against the German bund. The yield spread has increased by the end of 2011 except for Ireland. Chart 1 – Yield spreads of European bonds over German bunds (a) Source: Thomson Reuters Data stream and Bank calculations cited in Bank of England, 2011b, p.7. (a) Ten-year government and EFSF bond spreads over German bunds. (b) Spreads as on 15 June 2011 except for EFSF, which is as on 17 June 2011. (c) Spreads as on 22 November 2011.In May, Portugal becomes the third European country to seek financial assistance from European authorities and International Monitory Fund (IMF) (Bank of England, 2011a). Even though Greece and Portugal obtained financial support, market was concerned about the sustainability of their fiscal position. Chart 2 plots the yield on 10 year government bond of Greece which shows that the yield has come down in March 2012 and after that it shows a rising trend due to uncertainty about the financial stability of Greece. Chart 2 – Yield of 10 year Government bond of Greece Source: www.tradingecnomics.com / Public Debt Management Agency, 2012 During the same period Ireland showed a decline in bond yield (Chart 3). This is achieved by building confidence in economy though implementation of adequate fiscal adjustment measures. Chart 3 – Yield of 10 year Government bond of Ireland Source: www.tradingecnomics.com / Ireland Department of Treasury, 2012 Similarly the ten year Government bond yield spread for Greece (Chart 4) shows an increasing trend which confirms that the bailout package provided by the European Union (EU) and IMF has not provided the expected results. Chart 4 – Yield spread of 10 year Government bond of Greece (Bench mark – German Bunds) Source: Bloomberg, 2012. Another development in 2011 is the increase in the number of factors affecting the sovereign yield. After the introduction of Euro in 1998, the bond yield among the European nations remained the same (Chart 5) and during the period 2003-2007 the yield spread was very minimal due to abundant global liquidity. Chart 5 clearly shows that since 2007 onwards the bond yield shows a diverging trend. The increase in European bond yield spread in 2011 can be attributed to the fiscal sustainability concerns and risk aversion. Chart 5 – Yield spread of 10 year Government bond of European countries to 10 year German Bunds Source: Bloomberg Global Financial Data cited in www.rba.gov.au, 2012. Apart from the fiscal related concerns, the yield on European sovereign bond is influenced by strong demand for safe assets and change in investor demand. Chart 6 shows the yield spread between the government guaranteed agency bonds and sovereign bonds of Germany. It can be seen that during the tense times in 2011 the agency-sovereign spread was around 60 basis points which is attributed by the better liquidity of the sovereign bond compared to the agency bond. In 2012, with the improvement in financial markets the agency-sovereign spread shows a declining trend. Chart 6 – Yield spread between the government guaranteed agency bonds and sovereign bonds of Germany Source: Thomson Reuters and European Central Bank cited in European Central Bank, 2012, p.22. The performance of European sovereign bonds for the past 18 months shows that country wide effects like fiscal situation, economic outlook, risk aversion among investors and portfolio shift to safe assets are influencing more in driving yield development.Performance of Corporate BondYields of corporate bond also showed divergence across European countries similar to sovereign bond. Investors now apply more rigorous risk pricing methods to individual company specific risks within the same country. Chart 7 and 8 shows the yield curves for the covered bond markets of Germany and France which are estimated for various issuers in these markets. The dispersion of yield for individual bonds in both countries was high in past 18 months compared to that observed in 2008. This shows that the yield of corporate bond is changing not only with respect to country of origin, but also with individual issuer. Chart 7 – German covered bond yield curve in 2008 and 2011 Source: Bloomberg and ECB calculations cited in European Central Bank, 2012, p.24 Notes: For both years, the first Monday of the second half of the year (in July) is chosen. Estimated par yield curves (solid lines) and observed yields to maturity (points) are presented. Chart 8 – French covered bond yield curve in 2008 and 2011 Source: Bloomberg and ECB calculations cited in European Central Bank, 2012, p.24 Notes: For both years, the first Monday of the second half of the year (in July) is chosen. Estimated par yield curves (solid lines) and observed yields to maturity (points) are presented. Future of the European Bond MarketFor the next 12 months the outcome of the elections in European counties will have a major impact on investor confidence and global growth expectations. The citizens of Ireland, Spain and Portugal have already voted to change their government and Greece is moving forward to a coalition government. Among the four, Ireland showed a decline in yield on bonds, but it has the worst public finance in Europe. For the other three, a turnaround will be less likely for the next one year since they have got large fiscal and trade deficit, look uncompetitive and needs support for years. One of the options to ease the European crisis is to go for large scale bond buying of the affected countries by the European Central Bank (ECB).But such purchases are against the ECB rules and can slowdown the fiscal and structural reforms adapted by the members of EU. This can bring future losses to the ECB and its member banks. ECB and Germany are of the opinion that the eu ro zone government has to support the peers using the funds raised though European Financial Stability Facility (EFSF) or obtained from IMF (Ian Campbell, 2012). But this route can burden the core economies which are at risk themselves and further worsen the situation. Conclusion Predictability attracts long term investors in betting a currency or trading in a bond. But the euro area faces political and financial uncertainty. The future of Greece, lately a byword for ‘Euro-geddon’, will be decided by voters those who are fighting against the imposed austerity measures by the EU and IMF and those who want a stable future for the euro. Crisis in some European area sovereign debt markets and their impact on credit conditions along with high unemployment are expected to dampen the underlying growth momentum. The US market is also having uncertainty because of the presidential election planned to be held in November 2012.Presently investors in bond markets are looking for safe heavens with reasonable returns. South East Asian and Australian markets offer a good opportunity for investment.Even though growth is slow along with global economy, these markets can still outpace the European and US markets. Appendix 1.1 Definition of Yield The yield of bond is defined as the single discount rate when applied to all future interest and principal payments produces a present value equal to the purchase price of the bond. The yield depends on the risk involved in holding the bond. A greater risk can fetch a higher yield and a lower risk will result in lower yield.1.2 Definition of Yield spreadYield spread is defined as the difference between yields of two bonds. Usual practice is to fix the yield of one bond as a benchmark and to calculate the yield spread of other bonds. The yield spread is generally specified in basis points and a difference in yield of one percent is equal to 100 base points. Yield spread helps the bond trader to get a clear picture of relative movement of the bonds. Finally it is used as a tool to decide the buying or selling of a bond. Reference List Bank of England, 2011a. Financial Stability Report June 2011, Issue no 29. [pdf] London: Bank of England. Available at: [Accessed 23 May 2011]. Bank of England, 2011b. Financial Stability Report December 2011, Issue no 30. [pdf] London: Bank of England. Available at: [Accessed 23 May 2011]. Bloomberg, 2012. Snap shot of Greek-German spread (.GRGER10). [online] Available at : [Accessed 23 May 2011]. Campbell, I., 2012. Another Year of Living Euro-Dangerously. Reuters Breakingviews, p.37. European Central Bank, 2012. Financial Integration in Europe April 2012. [pdf] Frankfurt: European Central Bank. Available at: [Accessed 23 May 2011]. Gartside, N., 2011. Global Bond Outlook. [pdf] New York: J.P.Morgan Asset Management. Available at: [Accessed 23 May 2011]. Reserve Bank of Australia (RBA), 2012. Graphs. [online] Available at: [Accessed 23 May 2011]. Tradingeconomics, 2012. Greece Government Bond 10 Y. [online] Available at : [Accessed 23 May 2011]. Tradingeconomics, 2012. Iel and Government Bond 10 Y. [online] Available at : [Accessed 23 May 2011]. Bibliography Bank of England, 2010a. Financial Stability Report June 2010, Issue no 27. [pdf] London: Bank of England. Available at: 0http://www.bankofengland.co.uk/publications/Pages/fsr/2010/fsr27.aspx [Accessed 23 May 2011]. Bank of England, 2010b. Financial Stability Report December 2010, Issue no 28. [pdf] London: Bank of England. Available at: [Accessed 23 May 2011]. European Central Bank, 2011. Financial Integration in Europe May 2011. [pdf] Frankfurt: European Central Bank. Available at: [Accessed 23 May 2011]. Forbes,S.M. et al, 2008. Yield-to-Maturity and the Reinvestment of Coupon Payments. Journal of Economics and Finance Education, 7(1), p.48. Jorg Homey and Michael Spies, 2011. The German Pfandbrief Market 2011-2012. Hamburg: Deutsche Genossenschafts-Hypothekenbank AG, Rodrigo, 2012. Report on the European Bond Market- March 2010 to August 2011.[online] Available at: [Accessed 23 May 2011]. How to cite Report on the European Bond Market – November 2010 to April 2012, Essay examples