European Debt Yields Indicate Fear

Across the European continent debt yields on existing debt are rising and indicate a growing level of fear about their nagging debt crisis.  Specifically, last week yields rose in Portugal, Italy,  Ireland, Greece and Spain – alias, the P.I.I.G.S. nations.  But even the bonds yields of Europe’s strongest economy, Germany, rose this past week.

Why are rising yields evidence of fear?  Let’s start with the price of a bond because it makes the case more obvious.

If the perceived risk of default on existing debt obligations rises in a country, say Greece, what is the natural outcome for investors?  That they demand less of those bonds.

What happens when the supply is fixed and demand falls?  That’s right, prices fall.  This is true for any good or service, not just debt.

Yet, the interest payment on these existing bonds is contractually fixed.  So when the price of the bond falls, and the interest payment remains the same, then the yield on the debt rises.

A numerical example will help illustrate this point.  Here I am going to imagine the following:

• Country in question: Italy
• Maturity of bond: 10 years – that is, the length of the contract is for ten years.  This is just like a mortgage.  If it’s a 30 year mortgage it means the contract is up in 30 years.  So this Italian bond’s contract is up in 10 years.
• Cost of a bond at issue: €1.000 (that’s 1,000 for my U.S. readers)
• Coupon/interest payment on that bond: €30

So the yield on the bond at issue is €30 ÷ €1.000 = 3.00%.  Does that make sense?

Now what happens if people get a bit nervous about Italy’s ability to pay its debts and they demand Italian debt less?  The price bid by a prospective buyer is going to drop.  Imagine that investors in Italian debt are only willing to bid €950 now because of their solvency concerns.  What happens to the yield on the 10-year bond now?

• Price of the bond: €950
• Coupon/interest payment on that bond: €30

So the yield on the bond after the debt fear increases: €30 ÷ €950 = 3.16%  That’s a rise in yield of: 3.16% (current yield) – 3.00% (yield at issue) = 0.16% or 16 basis points in the parlance.  Thus, rising yields are an indication of an increase in nervousness.

In Europe yields on government debt are reaching all time highs since the introduction of the euro.  This is another way of saying that the current debt crisis has investors in Europe their most nervous ever.

That is important and noteworthy, especially since the root causes of the crisis have not gone away.

Jason

P.S. – I know that many of you come to the blog multiple times a day – thank you – might I recommend in those moments when there is not a “new” post that you check out one of the posts in the “Best of the Blog” section?  For example, I think the best piece that I have ever written, Solely Analytical Methods Are Doomed to Failure, would be a good place to start.

P.P.S. – I am happy to note that this is my 800th blog post; wow, are my fingers tired!