Join our community of smart investors

Punts on bunds

BOND OF THE WEEK: Trading the yield premium between core and peripheral Eurozone debt

The European debt crisis is at the forefront of investors' minds. EU member states are arguing over Greek debt and the proposed issue of guaranteed "E-bonds". There's another crisis summit, against the backdrop of plunging Spanish and Italian bond prices and sharply higher yields.

Whilst this may all be of great interest to economic historians and bank proprietary traders, it is not immediately evident how the typical sterling-based UK investor would benefit from what are quite sharp fluctuations in prices and yields of European government bonds. Direct purchase of some of the higher yielding members would be one interesting strategy for playing any recovery, and some of the yields on offer are quite tempting: Spainish ten-year debt yields 6.2 per cent, Portuguese 11.7 per cent and Irish 13.4 per cent.

However, investors taking the direct investment route will need a reasonably large portfolio, and strong tolerance for risk & volatility and a broker capable of executing and providing custody of European sovereign bonds.

The spread betting providers have recently responded to the increased interest in this financial situation by offering prices in the Italian ten-year BTP contract. This joins the already-established ten-year German Bund contract as one of the major financial instruments open to private investors and traders. The addition of the Italian BTP contract will allow traders to place spread trades between the high-quality Bund and the more risky BTP; a type of trade that has been the meat and drink of bank proprietary traders for many years.

So how to start? The chart above shows the historic spread between the yield on the 10-year BTP and the yield on the equivalent bund. Back in the early 1990s, a three to six percent yield premium was the norm for the BTP. Then came the great convergence trade. With European monetary union underway, traders shorted the Bund and bought the BTP, enjoying a two- to three-year bull run as BTP yields fell down towards German levels.

Next came the period of complacency. From the millennium through to the early 2008, the German and Italian bonds were considered almost interchangeable, with only a tiny risk premium for the BTP. This is no longer the case, and BTP yields are on the rise - sharply. Ten-year Bunds now yield 2.7 per cent whilst their Italian cousins offer 5.7 per cent, having briefly pushed above the 6 per cent mark in panic trading earlier this week.

See other Bond of the week features

Check out our free investment guide to bonds.

Daily prices, charts and data for gilts, linkers, corporate bonds and Pibs - now includes downloadable prospectuses for Pibs issues!