The sovereign debt of Greece has been seen as a pariah asset class, but yields have fallen to lows not seen since 2010.John Kolesidis/Reuters
Europe's fragile bond market is gaining strength as investors find the courage to buy more of the region's sovereign debt.
Because European governments have made big strides to get their fiscal houses in order and economic growth is starting to return in the euro zone periphery, bond yields in once-toxic countries such as Greece, Portugal and Spain have plummeted to levels not seen in years. Greece's 10-year debt now yields 7.38 per cent, the first time it has fallen this low since early 2010, while Spain's 10-year bonds now yield 3.6 per cent, its lowest level since the start of the financial crisis.
Amid the growing confidence – bond yields and prices move in opposite directions – Portugal launched its second government bond issue of 2014 on Tuesday, issuing €3-billion ($4.5-billion) worth of debt. Investors were happy to scoop up the issue, helping the country sell more than half of the total debt it needs to raise this year.
Market optimism is so high that even Greece, which was thought of as an economic basket case just months ago, is openly floating the idea of issuing public debt later this year. Investors still seem cool to the idea, so the dream is likely still far off, but the country's primary surplus – an annual surplus before interest payments – has made the prospect of a debt issue at least look a little more attractive.
"Sovereigns in the euro area have had a Goldilocks start to the year," Société Générale strategist Ciaran O'Hagan wrote in a note to clients, adding there is more room for yields to fall, because bond spreads are likely to tighten as the euro zone's economic picture improves.
The prospects of lower sovereign yields are aided by the region's interest rate outlook. Lately there have been questions as to whether the European Central Bank will cut interest rates to stave off deflation, and even if the ECB stays put, the expectation now is that its benchmark rate will remain low for years, forcing investors of all stripes to hunt for decent returns.
"There is an ongoing grab for yield," said Mark Dowding, fixed-income portfolio manager at BlueBay Asset Management. Bond buyers such as insurance companies can only scoop up so much longer-term debt – which pays higher yields – so these investors are finally coming to terms with buying shorter-term sovereign bonds that compensate them for their risk.
As of Tuesday, 10-year Italian and Spanish bonds still paid roughly 200 basis points more in annual interest over German bonds. These spreads, coupled with the countries' improving fiscal outlooks, are also attracting bond buyers from countries such as Japan and the U.S., proving that the rest of the world is getting comfortable with the euro zone.
"The only question," Mr. Dowding said, "is how much further has that trend got to run?" Like the Soc Gen's chief strategist, he believes the buying will continue and spreads should tighten – especially because there aren't many scheduled political events on the horizon that should force investors to be cautious.
But he stressed that it won't always be smooth sailing from here. "Over time, it will be a case of three steps forward, two steps back in Europe," he said.