Yield Compression in the Eurozone

March 27, 2015

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward-looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

On March 5th, Mario Draghi, President of the ECB, announced the details of the QE program and surprised markets by stating that purchases would include issues with maturities as far out as 30 years, causing a compression in yields (actual purchases by the ECB and various national banks began on March 9th). As the chart demonstrates, the largest yield compression has occurred in German bonds, where yields on 30-year maturities were 0.633% on Wednesday morning, down from 0.946% on March 5th. The spread between 2 and 30-year German bonds is currently 87 basis points. Yields for some of the riskiest longer-dated European debt (demonstrated here by Spanish and Italian bonds) have also seen compressions, though the spread between 2 and 30-year yields remains around 2%.

What does this mean for investors and the ECB bond buying program? Given the inverse relationship between bond yields and prices, the notable drop in yields has benefitted investors. However, reinvestment risk is a significant concern for investors should they sell their current holdings, as they would then have to purchase newer bonds that feature lower yields and coupons. Unless immediate cash is needed, bond investors will be loath to give up their higher yielding bonds in exchange for lower yields. Some wiggle room will be available as the front runners of QE look to cash in their profits, but others may hold out for a time since the ECB is a large, price indifferent buyer. Eventually, supply will normalize, possibly through a combination of profit taking and the ECB “nudging” those stubborn bondholders to sell.