Euro-Zone Political Risks Lead to Subtle Hedges in Bond Markets

(Bloomberg) -- Hidden under the surface of European bond markets, traders are placing bets that will pay out if the risks in the euro zone severely escalate.

Markets across the continent have started to price in the increased potential for anti-euro candidates to win elections in France and Italy. Recent positioning in German and Italian bonds are hedges against a blow-up in the risk of a breakup in the common currency, said traders in London and New York, who asked not to be identified because they are not authorized to speak publicly.

Six-month German securities have rallied more than benchmark tenors this month and open interest in two-year note futures has surged, suggesting investors are building up long positions in assets that are the closest to cash in terms of safety. The yield spread between Italian low- and high-coupon bonds has widened as traders bet against the latter, which would fall much more if the country’s creditworthiness is called into question.

• The front end of the German yield curve has outperformed over the past three weeks, with 6-month and two-year yields dropping 10-14 basis points, while open interest in two-year futures has jumped by more than 100,000 contracts

  • In the event of a euro-zone breakup, the safest thing to hold would be cash, and these are the assets closest to cash

• Moves in the relative value of Italian bonds also show signs of hedging

• Bonds with higher coupons trade above par, and these higher priced bonds stand to lose much more in the event investors worry about a possible haircut in the event of a default

To contact the reporter on this story: Stephen Spratt in London at sspratt3@bloomberg.net.

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Neil Chatterjee, Keith Jenkins

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