German bond buyers seen undeterred by zero yield

LONDON: Investors are expected to buy a new German two-year bond at auction next Wednesday, even if it offers no return on investment, as demand for such safe and low-risk assets allows the country to borrow for free.

German two-year bond fell below zero for the first time in June and settled in negative territory from early July onwards as concerns about the ability of the euro zone to recover from its debt crisis deepened.

At the week's only bond auction, the new September 2014 bond due to be sold next Wednesday is expected to carry a zero percent coupon - meaning it does not pay interest to the holder - as did a previous two-year bond launched in May.

However, as the safest sovereign bonds in the euro zone, the huge market for German debt means Schatz bonds can be quickly and cheaply turned into cash and so remain popular with banks seeking to bolster their balance sheet.

"The preference for some liquid short-term paper should remain unbroken," said Commerzbank strategist Rainer Guntermann.

Underlining this persistent demand, while longer-term German debt has sold off steeply this week, pushing yields up by 14 basis points, the Schatz yield has risen only 3 bps.

Cash market yields of minus 0.035 percent on the existing two-year benchmark could rise as the sale approach as markets try to eke out some return on their investment by selling in advance of the auction in an effort to push down the price of the new bond.

"I would imagine the market will try to get it at a positive yield, even if that's 0.01 percent," said Marc Ostwald, strategist at Monument Securities in London.

While sentiment has been calmed by the prospect of European Central Bank action to relieve pressure on Spain, sentiment remains fragile and while a successful auction was expected, the strength of demand could be determined by the market's mood.

"It only takes one headline to upset the market or have it reaching for higher yields and so-called 'risk', but then I suspect the front end of the curve is still somewhat immune to that," Ostwald said.

Demand should be sufficient to ensure bids worth around 1.3 to 1.4 times the 5 billion euros on offer, he said.