Risk buys, High volume (update 1) re: ECB/EU zone bonds

"It is tempting to see Tuesday's successful debt auctions by Ireland, Spain and Hungary as a sign that the recent global market jitters are behind us.

But we shouldn't confuse the favorable price and risk dynamics driving yield-seekers into these sovereign debt sales with a reversal in the low-growth outlook weighing on stocks and other risky assets. That depressing global reality is still with us.

Sure, Ireland's heavily oversubscribed auction of €1.5 billion in four- and 10-year debt was welcome news. Over the past week, fears of a new crisis there had roiled markets.

But think about it. If you can borrow short in euros at close to the European Central Bank's 1.0% reference rate, the 5.39% paid by the 10-year Irish bond and the 3.63% on the four-year are pretty attractive.

Since the T-bills Spain sold on Tuesday fall due in just 12 and 18 months, the same goes for their 1.90% and 2.15% respective yields.

And although the forint-denominated debt of Hungary presents a bigger risk, improved sentiment in the euro zone makes a strong case for betting on that euro-aspiring sovereign too. After all, the juicy 5.28%-yielding T-bills it auctioned on Thursday will be repaid in three months, and even the International Monetary Fund said the country faces no refinancing challenges until 2011.

The fact is, following the bombshell announcements of May 9, medium-term default and price risks in the euro zone have significantly eased. That is when euro-zone governments created a €750 billion guarantee fund to backstop struggling members, and the ECB promised to buy government bonds in the secondary market.

While doubts persist about how the bailout fund will work, for now investors can and should take the pledge at face value. The euro zone will guarantee Ireland's, Spain's, Portugal's and any other stumbling government's debt. So why not buy it?

Meanwhile, the ECB's low-profile bond purchases have provided a steady source of price support to the market.

So in theory, the only risk an investor in Irish or Spanish debt need think about is inflation. And who on earth is worried about that right now? Deflation is the fear du jour, and if the rate of consumer price increases goes to zero or negative, those 3.6% nominal four-year yields look even better.

Yet deflation is precisely why investors should remain worried, certainly about investing in equities or any other growth-linked assets.

Were deflation to bite hard, it would inherently revive default risks in peripheral euro-zone countries or at least that risk that the bailout fund has to be activated. While creditors enjoy higher real yields at such times, borrowers' debt-servicing costs only go higher. If inflation is a friend to debtors, deflation is their enemy"

from WSJ Aug 16 2010