From gilts to bunds or treasuries, not to mention the wide spectrum of other less widely known debt instruments; and even the probably irrational exuberance afforded by the more exotic options available to the bond investment community, bond investors need to discover not only the highest payout (interest) for their investment, but also the safest one. Buying a high yield bond of a country about to go bankrupt does not an investment make, unless of course you are a private "Bad Bank", in which case all that remains to be said is "buyer beware". Fasten your seat belts; for this article, we'll take a trip to Europe.
The inherent financial risk of a fundamentally frail political union like the Europen Union (EU) possessing a strong currency should not be overlooked. One builds upon the other, so if one gives, the other is bound to follow. Which is why the benchmark for all debt European is German bonds. Germany is the healthiest (though not necessarily healthy when compared to other times) EU economy and its sheer size relative to the other European economies gives it a dominant role and say within the Union and the European Central Bank (ECB). So German bonds are the favorite investment of safety seekers and the first stop each time the "flight to quality" begins.
Lesser economies, often debt laden, are called "peripheral" or "satellite" economies. These include countries such as Greece, Portugal and most of the newer EU members. Spain and Italy are a lot larger than these nations, but due to their erratic fiscal performance over the years, they are closer to this category than the major Europe players. France is a bizarre case of a basically major league player and then there is the UK – a decidedly European, Ivy League player who stubbornly stays out of Euro.
Recent global financial woes left their mark in Europe as well. And perhaps not surprisingly, the play took an interesting turn: investors began to snub some of the debt issued by peripheral economies. This could not come at a worst time for these countries. Because of the crisis, most - if not all - governments needed to issue more debt in an attempt to jumpstart their unstable banking sector and economies in general.
Greece, Spain and Ireland in particular needed to raise large sums fast. The UK will likely need to follow as well, to fund the bailout/nationalization schemes in the UK banking sector. Austria's exposure to Eastern Europe's banking sector seems to be around 70% of its GDP, which is frightening indeed and could prove disastrous. Ireland's fiscal problems are also frightening. Any analysis worth the paper it is printed on should take into consideration that there actually exists a possibility of default for all debt, be it German, UK or, say, Portuguese bonds.
One should also take into consideration the possibility that because of the nature of the crisis, monetary measures and "stimulus" packages are not only irrelevant, but also fundamentally flawed as a solution framewor. Therefore not only will the global economy not pick up as a result, but the crisis may still worsen as a result of the added debt.
Assuming both doom scenarios above are out of the picture, the smart way to play the bond game is to take advantage of the wide spreads between German and the other European bonds.
Buying gilts has paid off so far, as the UK has traditionally been a reliable economy. But the real potential, if one has the stomach and the deep pockets for it, is capturing the spread between Greek and German bonds (recently between 200-360 bp!), as well as Spanish bonds (steadily more than 100 bp) and those of other peripheral European economies.
I would not really look into anything expiring more than 12 months ahead (as a directional long holder) although obviously there may be some very creative ways to exploit expirations well beyond that.
For the investor who doesn't subscribe to the doom scenarios but is reluctant to venture into the more exotic options described above, there has never been a wider spread between German and UK bonds.
The UK economy is already boosted by the recent devaluation of the GBP and although the banking sector is in bad shape, there seems to be no immediate danger, unless there are more skeletons hidden away. Feb 2009 MPC minutes show that the crisis is not being taken lightly, and some of the comments are pretty convincing and on target, in my opinion. Once a bit of institutional buying going on at the moment is out of the way, conditions for buyers may even improve further.