Duration Lesson

July 26th, 2016 10:24 am | by John Jansen |

Via WSJ:

The German Yield Curve is Getting Kinky

Blame the ECB’s era of low rates, which makes 12 years is more expensive than 10

Germany’s yield curve is getting kinky. The European Central Bank’s extraordinarily easy monetary policy has led to an unusual kink in the path of bond yields, with the 10-year bond offering a higher yield than the bond maturing in 12 years.

The shape of yield curves is closely watched by investors, and usually arbitrageurs step in whenever bonds get out of line.

But the speed of rate cuts since the financial crisis has created an odd situation where the bonds maturing further in the future look more attractive to investors, who are paying more than they normally would and so taking a lower yield.

ENLARGE

The latest 10-year bond, issued this year, will make no payments until it matures in August 2026. The bonds maturing in 2027 and 2028, having originally been issued in the late 1990s, pay annual coupons of 6.5% and 5.625% respectively.

The normal action of bond markets led the price to rise as rates fell over the past two decades, meaning both still offer a negative yield to maturity. But the higher coupons make the bonds look more appealing as more of the total value will be received earlier. In bond jargon, the 10-year bond – where all the value lies in the final payment – has a longer “duration” than the 11- and 12-year issues, where almost half the value comes from the coupons along the way.

Investors would rather receive their money sooner, which helps to increase the value (and so reduce the yield) of the later-maturing bonds.

New kinks are likely over the next few years as Germany’s new zero-coupon 10-year issues overlap in maturity with high-coupon older bonds, including a 6.25% 2030 maturity.

More important than any kinks is the broader shape of the yield curve. With relatively little difference between bonds maturing soon and those maturing in a decade, the curve is very flat – meaning little extra reward for locking up money for the long run. This is bad for banks, and suggests little faith that the ECB’s easy money will get the region’s economy moving again.

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