But wait, do French OATs REALLY trade at a spread over Italian BTPS?

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Last week — the morning after FTAV London drinks — it was Robin’s turn to write the charts quiz. He was sleep deprived, generally quite busy, and perhaps a tad hungover. So being a keen new joiner, I sent him a few suggestions for the quiz — including the yield differential between 5yr French government bonds and 5yr Italian government bonds:

This is how the sausage is made.

You can read the post that popped out a couple of hours later here. Basically, it says “five-year French benchmark bonds now trade with a higher yields than five-year Italian benchmark bonds for the first time in like pretty much ever” in 400 words using four charts.

For some readers, this was at least 377 words and three charts too many. And those readers should stop reading now.

Others contacted us to challenge the substance of the post. Is it really true that Italian government bond yields are lower than French government bond yields?

The short answer is that five-year benchmark Italian bonds do trade with a lower yield than five-year benchmark French government bonds. But this may say more about the selection of benchmark bonds than it does about the perceived relative credit risk of the two sovereigns.

As a reminder, this is the chart showing that the yield difference between French and Italian bonds at the two-year and five-year tenor points had turned negative:

What even is a benchmark bond?

Looking at the yields of all the French and Italian conventional fixed-rate bonds, one might reasonably assume that the two-year and five-year benchmark bonds are the bonds with a maturity closest to two years from now and five years from now:

This assumption will usually be wrong.

Benchmark bonds are supposed to be the most liquid tradeable bond of a particular tenor. Want to buy five-year bonds after seeing that five-year yields trade at 2.7 per cent? Then buy the five-year benchmark bond — rather than some weird off-the-run bond that offers a few extra basis points of yield but will cost a fortune to trade.

Let’s look at the chart again, this time with the bonds selected as two-year and five-year benchmarks by Bloomberg (enlarged dots):

You’ll notice that the French five-year benchmark bond matures seven months later than the Italian five-year benchmark bond. And the French two-year benchmark bond matures in almost three years — more than a full year later than the Italian two-year benchmark bond that matures in only 19 months.

Eye-balling the chart, it feels fair to say that Italian bonds — more often than not — trade at slightly higher yields than French bonds of equivalent maturity (rather than lower, as might be suggested by our initial spread chart). But when the yield curve is steep, maturity date mismatches among the benchmark bonds of different issuers will impact a simple spread calculation. In this case, the impact is substantial.

Last Friday the yield on the Italian benchmark two-year bond was 13 basis points fewer than the French benchmark two year bond. But it was 14 basis point more than the French bond with the closest maturity match. And while the five-year benchmark Italian bond yielded less than the five-year French bond, it yielded 13 basis points more than the French bond with the closest maturity match.

We checked with Bloomberg to get to the bottom of how exactly they select their benchmark bonds. As we understand it, benchmark selections are made using a variety of criteria such as auctions, new issuance, years to maturity, market feedback and availability of pricing. Furthermore, we also understand that Bloomberg consults with Ministries of Finance when updating benchmarks. Precisely maturity-matching bonds to tenors does not feature as an overriding concern.

So, in short, *deep breath* because not all two year benchmark bonds mature in two years, and because not all five-year benchmark bonds mature in five years, taking the differences in yield between two year bonds or five year bonds (at a time when the yield curve slopes sharply up or down) as a first order proxy for the market’s gauge of relative credit risk between issuers can be problematic *exhale*.

Who cares?

In the scheme of things, none of this may be of earth-shattering importance. But similar data will filter through myriad client PowerPoint presentations and PDFs — maybe even to serve as a signal in some weird long-standing trading model — so we thought 761 words and three more charts on the subject were worthwhile. If you disagree, we understand.