In the past four years, the UK, US and Europe have pumped more than USD3,000 billion in to their economies by expanding central bank balance sheets. Unable to reduce record-low interest rates any further, their aim has been to encourage economic growth by increasing the amount of cash in circulation, keeping borrowing costs low and reviving consumer spending.
The success of this tactic is still a matter of debate, but one clear consequence of quantitative easing is that it has unnaturally pushed up the market price of government debt and, in turn, pushed down yields.
During the past two years, returns on five-year euro-area bonds have fallen to about 0.6 per cent from 2.75 per cent, hitting a record low of 0.24 per cent in 2012. Yields on debt with longer tenors have also plummeted, to 1.5 per cent from 3.5 per cent over this period for German bonds. In many cases, issuers are achieving negative real yield on their debt. This means the yield they are paying to investors is lower than the rate of inflation.
There is differentiation between yields on debt sold by countries in southern Europe, where the economies are more embattled, and those in the relatively more stable economies of northern Europe. For example, Spanish bond yields rose to 7.5 per cent in late 2010 and then dropped to 5 per cent, which is still well above the ten-year German bond yields.
This is a flight to quality in the euro region. Investors are afraid of the risk of the eurozone falling apart. This has created re-denomination risk in Europe, which we continue to see with lower rates in the northern zone compared to southern Europe. The north is benefiting from the issues in the south because investors can exchange sovereign risk for sovereign risk without leaving the currency. One could argue that the south is now in fact transferring value to the north.
The central bank actions have created a fantastic market for any issuer who needs to raise money from the capital markets. As long as they have a good credit profile, borrowers can raise long-term debt at extremely low prices from a diversified set of investors, as seen by Germany selling EUR184 billion of bunds last year alone. It makes sense for issuers to go for long maturities and lock in low interest rates.
* The full article is available on the Markets and International Banking website