Europe: When losing money makes sense

@CNNMoneyInvest July 16, 2012: 6:39 AM ET
bonds

Short-term bond yields plunged this week for the most credit-worthy governments in the euro area.

NEW YORK (CNNMoney) -- There is a remarkable trend developing in European bond markets, where investors are increasingly willing to lend money to certain governments in exchange for next to nothing.

In the most extreme example, yields on 2-year German bonds turned negative this week, falling to a record -0.5%. That means, in theory at least, investors could end up losing money if they hold the bonds to maturity.

Germany is the eurozone's largest economy and its bunds are considered among the safest assets available for investors who are expecting the worst. But the flight to safety is becoming more widespread as investors hunt for a marginally better return.

This week, 2-year yields briefly turned negative for France, while Denmark and Switzerland are more firmly below zero. Short-term yields for AAA-rated Finland and the Netherlands fell to record lows.

The trend reflects a heightened aversion to risk as Spain and Italy struggle to avoid falling victim to the crisis that dragged down Greece, Portugal and Ireland. Yields on bonds issued by Italy and Spain rose this week as investors demand higher premiums to hold debt that is considered risky.

"The rise in benchmark yields in say Italy and Spain to worryingly high levels shows a deep concern amongst many participants about their fiscal sustainability," said Andrew Milligan, head of global strategy at Standard Life Investments.

The yield, or interest rate, on a bond falls when prices rise. A negative yield means investors are effectively paying the government to take their money.

"The analogy I use is that it's like putting money under the mattress," said Schwab fixed-income strategist Kathy Jones. "Investors trust the core countries and non-euro countries to return their money, even it costs them something."

Some analysts say the surge in demand for short-term, ultra-safe bonds is due to moves by the European Central Bank, which recently cut the rate it pays banks to hold money overnight to zero.

Without getting a yield from the ECB, banks that want a safe place to park their money are looking elsewhere. And that means "the short-dated debt of the least risky economies in the single currency area," said Nicholas Spiro, director of London-based consultancy Spiro Sovereign Strategy.

There is another reason why the move helped drive down yields this week, said Tobias Blattner, a former ECB economist who now works at Daiwa Capital Markets in London.

The deposit rate serves as a floor for money market funds, he said, many of which stopped accepting inflows this week.

"Investors who normally park money in those funds need to put it somewhere else," said Blattner. Short-term bonds issued by AAA-rated governments, which are safe and liquid, are one of the main alternatives, he added.

The drop in short-term French bond yields this week represents a significant change in market sentiment toward President François Hollande, who came to power in May by campaigning against government austerity.

"For now, investors are giving Hollande the benefit of the doubt," said Nick Stamenkovic, a fixed-income strategist RIA Capital Markets in Edinburgh.

Despite his heated campaign rhetoric, Hollande has taken a more moderate approach since the election, said Antonio Barroso, an analyst at political research firm Eurasia Group.

"Overall, the strategy of Hollande regarding fiscal consolidation seems to be one of incrementalism and anticipated damage control," Barroso wrote in a note to clients. "The president knows that despite the current positive market environment, the pressure on French sovereign debt could return at any moment." To top of page

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