PARIS, Nov 30 – The European government bond market showed unease on Monday after firming sharply at the end of last week on a heavy flight of funds towards quality in the light of the debt crisis in Dubai.
But concern over public finances in Greece, a eurozone country, and the standing of Greek government debt bonds remains a focus of attention, as does the situation in Dubai where a partial default on state-backed property bonds has put a spotlight on emerging markets.
"The (European bond) market has less support than last week because the other emirates should support Dubai in the end," said bond strategist at BNP Paribas, Patrick Jacq.
Yields, or the interest which the market is signalling investors require for lending to different governments by buying sovereign bonds, were little different on Monday from levels late on Friday.
But the most easily traded and most highly regarded bonds in the eurozone, such as the German bund and to a lesser extent the French OAT, performed strongly last week, Jacq noted.
The sovereign bond, or fixed income, market is the market on which are traded bonds issued by governments to borrow money for a set period in order to cover a difference between annual public spending and tax revenues.
This difference in the eurozone is called the public deficit. Accumulated past deficits form the current debt owed by a country.
A government bond is therefore the right to an income stream for a given investment, which will be returned to the holder of the bond on the redemption date.
If the return carried by a bond begins to look unattractive, either because interest rates in general for the particular level of risk have risen, or because the perceived problems of the economy in question have risen, some investors will turn away from bonds already issued.
As the price falls, the income automatically rises as a percentage of the market price. This means that the government concerned will have to offer a higher rate of interest on any new bonds it has to issue to cover a continuing budget shortfall.
However, at times of great aversion to risk, many investors switch some of their funds into the safest instruments available, the bonds of the most highly rated countries, and this pushes down the yield on these top class assets. The range between yields on the best bonds, known as benchmarks, and other bonds is known as the spread or differential.
The credit rating of bonds and the consequent interest a government has to pay to attract funding are of vital importance to the overall economy. They have added importance in the eurozone because commercial banks can offer only good grade public bonds as collateral to borrow the cheapest money available, from the European Central Bank.
At midday on Monday, the Bund was yielding 3.158 percent from 3.262 percent on Wednesday and the OAT 3.422 percent from 3.510 percent before news broke that Dubai could not honour all of its state-backed debt.
That announcement reawakened concern on bond markets about the ability of some states to ensure they remained creditworthy, in the light of strains over Greece which is judged to have a worrying level of public deficit.
Greek bonds, which have fallen sharply in the last two weeks, did not benefit from the flight to quality on bond markets, and the problems in Dubai worsened perceptions of the situation for Greece.
Analysts at BNP Paribas spoke on Friday of a "Pandora\’s box" in Greece, remarking that Greek bonds were "suffering a massive widening" of spreads within the eurozone.
Referring to signals from the European Central Bank that it is ready to begin winding down crisis cash support for the financial system in the eurozone, BNP Paribas said: "The withdrawal of the liquidity umbrella has uncovered the structural problems around the fiscal situation in Greece.
"Although the move in the last two weeks looks overdone, it is not the first time that we have witnessed such violent jumps in Greek spreads. What is different this time is that Greece has been hit to a much larger extent than other peripheral countries."
It also commented: "The sensitivity of Greek bonds compared to their Irish or Italian counterparts is much higher this time."
At Cm-CIC Securities, bond strategist Valerie Plagnol said: "The situation of Greek public finances is worrying European authorities more and more.
"The first draft of a document will be published (this week) by the ministers of finance from the 27 (EU countries) indicating that \’the strong deterioration of Greek public finances cannot be blamed on macroeconomic conditions, but is more the result of inadequate response of Greek authorities\’."
In this context of tension over public deficits, credit default swaps (CDS), which are used as insurance policies for credit risk, have risen strongly in respect of some countries, such as Greece and Ireland.
Plagnol said: "The debt of other emerging countries risks coming under pressure because of their financial exposure, directly or indirectly, to Dubai."