What Are Bond Yields Telling Us?
By comparison, people seem to want German bonds so much they have bid them up to actually have a negative yield! They are not the only bonds priced like this. Currently there are several Switzerland bonds that have similar yields. So why would anyone pay so much for a bond to receive so little in interest? The easy answer and the one everyone in the financial press talks about is safety, or flight to quality, or risk off. People are so scared of investing they would rather have a guaranteed small loss than a possible huge loss by investing in something else. This is only part of the explanation. One possibility is that if you buy German bonds, what currency will you be paid in if they leave the Euro? A new Deutsche Mark? Very possibly! My personal belief is that this new potential Deutsche Mark would dramatically appreciate (at least for a short time) right after its release. If you hold one of the German bonds, you would make a huge return in the currency fluctuation, if not in the actual bond yield.
So instead of just believing the financial press when they say that bond yields are down because of a flight to quality, consider that these investors may actually be buying a call option on the possible future strength of a new currency! In fact, if the interest paid on the bonds is actually a bit on the positive side, beating inflation even, this is a FREE call option on a potential huge increase in the currency valuation of these bonds.
Rick Wright can be contacted at The Online Trading Academy