Why is European Debt so cheap? what caused the yields to plunge to such low levels? Considering the fact that some still see many problems in Europe with Slovenia needing a potential bailout and some (such as Matthew Lynn of Marketwatch) speculating that the Netherlands (or France could be next)? Why are yields on Italian debt close to 4%? Some wont consider this a great question as investors also are also buying Namibian debt for 4% yields.  There have been some theories offered on this question.

European Debt market

The Keystone Speculator  opines:

The European bond yields continue to drop over the last couple weeks which hints at calmness returning to Europe, however, digging deeper, the likely reason is the shift in Japan’s policies. The BOJ is determined to debase the yen and the easy money is chasing European bonds as well as U.S. dividend and perceived safe haven stocks. The rise in European bonds sends the yields lower. Italy is now down near 4% as the election drama continues to play out.

The answer makes sense, but are there other reasons to explain the phenomenon  Goldman Sachs is out with a new report and gives three good answers to dissect this question. Below is a summary.

Goldman’s take on European debt versus US

How puzzling is the contrast between diverging macro fundamentals and converging spreads; and is the current US and European spread differential mispricing the relative strength of the US? As we discuss in more details below, we think there at least three potential catalysts that have prevented the outperformance of US credits from being more pronounced this year:

First, the country composition of the EUR corporate bond market is not representative of the broader economy. For example, periphery countries represent a little more than 32% of the Euro area GDP but their weight in the corporate bond market is only 22%, vs. 55% for core Europe and 22% for non-Euro area domiciled issuers.

Second and somewhat related to the first argument, the reality of balance sheet fundamentals in the core of the Euro area is much less depressed than the broader economy. We examine credit metrics for core, periphery and US corporations, and show that credit metrics in the core of the Euro area compare favorably to the US. We also examine credit metrics in the CDX HY and iTraxx Xover indices and reach the same conclusion.

Third, we show that the structures of the USD and EUR markets exhibit important differences that could have made search for yield motives stronger in the EUR market. In particular, the smaller size of the EUR market and its shorter duration relative to the US might have pushed the premium to tighter levels than what macro fundamentals would otherwise warrant.

Goldman Sachs conclusion regarding future performance of European debt

These findings clearly suggest there is less upside in trading US credits vs. their European debt counterparts than we had initially thought. But overall, they do not change our positive relative value on US credit. The narrow spread differential shown in Exhibit 4 offers too little compensation for the relative tail risks. Macro risk remains orders of magnitude higher in Europe compared to the US in our opinion. And that makes the current benign default environment in Europe quite vulnerable for the next few years.

European debt: Making sense of the relative resilience of European credits embedded below

Goldman European Debt by ValueWalk.com