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Bittersweet and lowdown

15 April 2015 By Quentin Webb, Neil Unmack

Credit investors are locking in mediocre returns. With official interest rates near zero, inflation moribund and defaults low, investors are throwing money at corporate Europe. A new Breakingviews calculator shows how this generosity could backfire.


Suppose an outfit with a decent investment-grade rating wants 10-year money. Recent euro bonds from Carrefour, Danone and SCA suggest our borrower might offer a 1.25 percent yield.

Now skip forward five years, and consider possible yields. Today’s crystal ball is exceptionally murky. Still, Societe Generale analysts reckon 10-year benchmark rates will be 2.6 percent by 2019. Five-year rates would be lower, but you then need a “spread” to compensate for credit risk. So imagine, for argument’s sake, 3 percent would be an appropriate yield for our bond, now due in five years.

That yield would value the outstanding bond at 92 cents on the euro, the calculator shows – implying a 1.8 percent loss for any seller, including earlier coupon payments. So what, if you need not sell? Corporate debt purchasers typically “buy and hold.” That looks better, but not great. Redemption at par gives a 12.5 percent return, or a compound annual 1.2 percent.

That’s slim pickings, even before inflation. Suppose the European Central Bank works its magic and prices, now worryingly flat, start rising again. A decade of 1.5 percent annual inflation would turn every 100 euros of principal into 86 euros in today’s money, and also eat into coupon payments.

It gets worse for longer bonds. Novartis and GDF Suez recently sold debt due in 2035. Take a hypothetical 20-year bond yielding 1.5 percent now. That would trade at 72 cents in five years’ time if investors demanded 4 percent yields on 15-year debt.

Why do investors comply? It’s safer than buying shares, yields fractionally more than government debt, and can meet regulatory demands. Many doubt that either policy rates or inflation will pick up as hoped. And some may be consciously overpaying but counting on selling out to a “greater fool.” You can rationalise the behaviour, but this bond vintage looks like one to forget.


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