Demand boosts German 2yr debt sale

LONDON: A German auction of 3.4 billion euros of two-year government bonds drew solid demand on Wednesday, bolstered by a fresh bout of flight-to-quality flows after Moody's downgraded Portugal's credit ratings to junk.

The Portuguese ratings cut reminded investors that the worst of the debt crisis may be far from over, and pushed up the country's borrowing costs at a sale of 3-month bills as its debt yields hit euro-era highs in the secondary market.

Average yields at the Portuguese auction jumped to 4.926 percent from 4.863 percent at a previous sale, which were more than 130 basis points above what euro zone benchmark issuer Germany has to pay to issue 30-year bonds.

The Schatz auction fared better than a sale last week of five-year paper which drew poor demand because of low yields and as successful austerity votes in Greece eroded demand for safe-haven German bonds. Investors submitted bids for 2.3 times the total amount sold to investors, with the Bundesbank retaining 15 percent of the issue.

This compares with a bid cover of 1.4 times at a previous sale of the paper on June 15, where the retention rate was 17.6 percent.

"The bid cover of 2.3 is really strong, but also looking at the actual bidding, the issue came really quite expensive at 1.5 bps over secondary market levels and with a low tail which indicates very strong bidding," said Michael Leister, a strategist at WestLB.

"Obviously the reason is this risk-off mode again which has gathered further momentum this morning with the Portuguese downgrade. Against this backdrop it doesn't really come as a surprise."

Going into the auction, analysts had cautioned that the two-year area of the German bond yield curve did not look particularly attractive, especially given expectations of a European Central Bank interest rate hike on Thursday. But this was more than offset by the renewed tensions in lower-rated euro zone bonds after the Moody's move.

"Generally I would have expected it (bid/cover) to be on the low side. The last time we had this bid-to-cover was in June 2010. The road to high yields will be slow and we will have bumps on the road," said Glenn Marci, a strategist at DZ Bank in Frankfurt

The two-year Schatz yielded 1.645 percent, its lowest on the day, compared with 1.577 percent just before the auction. It was last down seven basis points on the day at 1.573 percent, leaving the German 2/10-year yield curve little changed at 138 bps.

Copyright Reuters, 2011