Some pigs can fly

What do Portugal, Ireland and Italy have in common? Their government bond markets have all produced a return of more than 20% in 2012. These numbers handily beat the around 4% return from German bonds. In fact, among larger Euro-zone countries, Germany has been the worst performer in 2012.

The Portuguese bond market has been the star performer of 2012, having returned more than 50% compared to the end of last year, followed by Ireland with a return of close to 30% and Italy with some 21%.

For the iBoxx Euro-zone government bond index (not including Portugal and Greece), the return for 2012 has been almost 11%, i.e. much higher than from German bonds. German bonds have not thus exactly been a top investment choice in 2012, though expected return is naturally only one component explaining the demand for German bonds.

One of the reasons behind the recent strong performance of e.g. Italian bonds has been the fact that not having Italian bonds in your portfolio has been expensive, if you still use a broad Euro-zone government bond index as your benchmark. Thus many have felt the need to add these bonds to the portfolio. After all, Italy has the biggest bond market in Europe, so its weight in indices is notable.

History is of course easy to call. More interesting is to try to estimate, what 2013 will have in store. A simple way to assess the attractiveness of bonds is to look at their yields. All major Euro-zone countries have seen their yields fall – most by a notable margin – compared to the end of 2011.

The room for yields to fall is thus smaller, while the expected interest income is lower. That said, many countries still offer notably higher yields compared to the overall index, and especially over German bonds. Even for Italian bonds, the current yield (of its bond index) is around 280bp higher compared to Germany, or more than double the German yield.

In an environment of huge liquidity, a determined central bank and low interest rates, carry trades are likely to continue to find demand. My bet at least is that Portuguese, Irish and Italian bonds will all beat German ones again in 2013.

Portuguese bonds the star performer in 2012

Yields fallen notably across the board in 2012

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