Bonds: a Crisis Risk Indicator?

As a risk professional you've learned to classify an increase in bond's interest volatility (or standard deviation) as an indicator that bonds have become more risky. Right you are....

Now, with this knowledge, let's take a look at the next chart, presenting the long-term (10Y) interest rate of some of the leading EU member states from January 1993 to April 2014:

This chart clearly shows that :

• Since the introduction of the Euro in 1999, country spreads start declining
• Interest rates converge to the year of the famous (Lehman) crisis in 2008
• After the 2008 crisis, rating agencies wake up and spreads explode again

Let's take a look in more detail, by some log scale zooming......

To find out if the convergence of interest rates really is a kind of early warning crisis indicator, let's add some more EU countries to the chart.

Now the picture becomes clear: A structural decline in bond's standard deviation is not a decline in risk, but more the opposite....

As standard deviation decreases, (crisis) risk increases!

We can check this by looking at the cross-country standard deviation development in time:

These charts, presented on a vertical linear and log scale basis, clearly  illustrate that as soon as the standard deviation hits the 0.2% level, crisis can be expected soon.

Not only is the 0.2% SD-level an early warning indicator for the 2008 crisis that started with the bankruptcy of the Lehman Brothers bank, but it's also an indicator of 'Dot Com' crisis in 2000....

Finally
Meanwhile... as from February 2012, standard deviations are declining  again. Time to worry?

Key questions are:

• when will standard deviation hit the 0.2% floor again? 
• and when it does, will there be another crisis?

Remember lesson number 1 in risk management: Crises are unpredictable!
Nevertheless, once 0.2% SD  turns up: fasten your investment seat bells....

Links/Sources:
- Spreadsheet of charts used in this blog
- EU Interest Rates
- Big Picture Chart