Question

Your uncle has recently retired with two million dollars of superannuation funds. He wants to invest a part of his super fund to fixed income securities, preferably foreign government bonds. He found Germany Government bonds offering YTM of 3% whereas Greece Government bonds offering YTM of 5%. He got confused with two different rates since both of them are risk-free government bonds.

Explain your uncle the underlying cause of 2% differences in YTM between these two Government bonds. Assume your uncle is a risk-averse investor, offer him your valuable advice to invest one of these two securities.

Answer 1

The difference in interest rate in the German bond and the Greece bond is because of the different level of risk even for sovereign bond and also because of the exchange rate. Sovereign bonds do have different level of risk associated with it because different countries have different credit rating of their sovereign bond. For example, the sovereign bond issued by US would have higher credit rating than a sovereign bond issued by an emerging market so the US bond will offer lower interest rate. Similarly, for German bonds the risk of default is very low but for the Greece bond the risk is higher than the German bond because in recent past they face issued while making the repayment so the Yield is different. He is in his retirement so he will be looking to invest where there is high security, also if the bonds are issued in Euro then his domestic currency does not matter because Greece and Germany both are part of European union but if the currency is different and his is a citizen of Germany then he should choose the German bond because it has low risk then the Greece and the exchange rate risk can also be avoided.