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Shopping for European bonds? Watch your step

Income is in short supply these days. With savings and money market account rates near zero and U.S. bond yields below 3 percent, investors are searching far afield for securities that will pay them a reasonable income yield. But could some of these investors be trying too hard to find income?

Recent movements in European bond yields suggest that investor appetite for income is becoming desperate -- and desperation tends to lead to excessive risk-taking.

The curious rise in European bonds

The hunger for higher-yielding alternatives is understandable. Saving account rates in the U.S. average just 6 basis points -- or $6 a year in interest on a $10,000 deposit. Ten-year Treasury bonds are yielding less than 3 percent, or below the long-term rate of inflation. In response, some investors are looking outside of the U.S. for income.

That search for income has led to something of a boom in the government securities of European countries. The problem is that when bond prices rise, their yields fall. Bonds from governments that were in dire straits a short while ago are now offering the low yields normally associated with high-quality securities.

Greece, which forced creditors to accept restructured payment terms two years ago, now has five-year bonds yielding less than 5 percent. Ten-year bonds from Spain and Italy are yielding barely more than 3 percent. This raises the question of whether investors are being adequately compensated for the risks they are taking.

The trouble with foreign investments

Investing in foreign government bonds raises a number of risk-management issues:

  1. Default risk. Investment in the bonds of fiscally troubled European countries reflects confidence that the European Union ultimately will back the bond issues of its member nations. Given the rising tensions among EU member nations over financial affairs, that may not be such a safe bet. In any case, recent history has shown that even if a country does not default completely, fiscal crises may result in a delay of interest payments.
  2. Currency fluctuations. From a U.S. investor's standpoint, another risk of investing in foreign government bonds is that fiscal problems can cause a country's currency to be devalued, which would result in a reduction of the value of a bond's principal and interest in dollar terms.
  3. Inflation. A major problem with low yields in general is that they may not even keep up with inflation. This inflation risk is compounded by the fact that irresponsible fiscal policies could lead to a flare-up of inflation within specific countries. That would cause yields on the bonds of those countries to spike, which would mean sharply falling bond prices.
  4. Time frame. The term length of income investments is a very sensitive issue in this environment. When it comes to countries with an extensive history of fiscal mismanagement, investing in long-term bonds means leaving plenty of time for the next crisis to develop. Also, the longer the bond term, the greater the chance that interest rates in general will return to normal before the maturity date, which would be bad for investors locked in at lower yields.

The role of income securities is to bring stability to a portfolio. However, by compromising risk management but getting little yield in return, investors in European bonds today may find they get neither much income nor stability from their investments.

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