Skip to content

Comparing International Bond Yields

Tuesday, August 5, 2014

In mid-2012, yields on 10-year Italian and Spanish government bonds were more than 4 percentage points higher than yields on 10-year German and U.S. government bonds. Since then, spreads have narrowed to the point where the yields on Italian and Spanish bonds nearly match those on U.S. securities. Christopher Neely, an assistant vice president and economist with the Federal Reserve Bank of St. Louis, examined whether this means the default risk for Spanish and Italian bonds is comparable to that for U.S. bonds in a recent Economic Synopses essay.

The European Central Bank

The reason for the spreads two years ago was the perceived risk of default by the Italian and Spanish governments on their debt, given their fiscal problems. This risk became a concern for the existence of the euro and a matter of great concern for the European Central Bank (ECB). In July 2012, ECB President Mario Draghi stated, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Following this statement, spreads narrowed significantly between Spanish/Italian bonds and U.S. Treasuries, and also between Spanish/Italian bonds and German bonds, though not as significantly, as spreads were still at about 1.5 percentage points as of late June. Neely noted, “Although the differences in euro area yields … are almost entirely due to default risk, the yields on U.S. Treasuries are not, in fact, directly comparable to those on Spanish or Italian government bonds. Why not? The difference lies in the fact that U.S. Treasuries pay in dollars and Spanish and Italian government bonds pay in euros.”

Exchange Rates

Neely explained that investors have to consider all risk factors, including the expected return on the exchange rate. He said, “Exchange rate changes are essentially unpredictable over any short period, but there is reason to believe the changes reflect bilateral differences in inflation rates over long periods, such as 10 years.”

The year-over-year euro area consumer price index was 0.5 percent versus 2.1 percent for the U.S. in May 2014, and inflation swaps1 predict 2.6 percent inflation in the U.S. versus 1.7 percent inflation in the euro area over the next 10 years. Neely said, “Lower inflation in the euro area suggests the euro might be expected to appreciate 0.9 percent annually against the dollar, mostly offsetting the 1.3-percentage-point difference in yields between U.S. Treasuries and German [bonds].”

Neely concluded, “In summary, Italian and Spanish government bonds still have a non-negligible risk premium compared with either lower-risk German [bonds] that also pay in euros or U.S. Treasuries after accounting for the expected changes in the exchange rate.”

Notes and References

1 Inflation swaps are derivatives that provide market-based measures of expected inflation.

Additional Resources

Posted In FinancialInflation  |  Tagged 10-year bondschristopher neelyecb
Commenting Policy: We encourage comments and discussions on our posts, even those that disagree with conclusions, if they are done in a respectful and courteous manner. All comments posted to our blog go through a moderator, so they won't appear immediately after being submitted. We reserve the right to remove or not publish inappropriate comments. This includes, but is not limited to, comments that are:
  • Vulgar, obscene, profane or otherwise disrespectful or discourteous
  • For commercial use, including spam
  • Threatening, harassing or constituting personal attacks
  • Violating copyright or otherwise infringing on third-party rights
  • Off-topic or significantly political
The St. Louis Fed will only respond to comments if we are clarifying a point. Comments are limited to 1,500 characters, so please edit your thinking before posting. While you will retain all of your ownership rights in any comment you submit, posting comments means you grant the St. Louis Fed the royalty-free right, in perpetuity, to use, reproduce, distribute, alter and/or display them, and the St. Louis Fed will be free to use any ideas, concepts, artwork, inventions, developments, suggestions or techniques embodied in your comments for any purpose whatsoever, with or without attribution, and without compensation to you. You will also waive all moral rights you may have in any comment you submit.
comments powered by Disqus

The St. Louis Fed uses Disqus software for the comment functionality on this blog. You can read the Disqus privacy policy. Disqus uses cookies and third party cookies. To learn more about these cookies and how to disable them, please see this article.