The perception of higher risk related to Luxembourg’s sovereign debt is reflected in the rising cost of its government bond yields compared to those of neighbouring euro area states. Photo: Shutterstock

The perception of higher risk related to Luxembourg’s sovereign debt is reflected in the rising cost of its government bond yields compared to those of neighbouring euro area states. Photo: Shutterstock

Since August 2021, Luxembourg’s government bond yields have exhibited a consistent upward trend, resulting in an increase of 358 basis points by March 2023. A recent surge in the spread between Luxembourg’s bond yields and those of other euro area countries indicates concerns among investors. However, the ministry of finance told Delano that government coffers remain resilient.

The start of 2016 witnessed a due to concerns over China’s economic slowdown, falling oil prices and uncertainty surrounding central bank policies. Consequently, investors turned to safer assets such as German government bonds, causing their yields to decrease and leading to wider yield spreads with riskier bonds.

Despite Luxembourg’s economic stability, its bonds may have been perceived as relatively ‘riskier’ compared to countries like Germany or other euro area member states. This perception led investors to demand higher yields as compensation for the perceived risk associated with Luxembourg’s sovereign debt, ultimately widening the yield spread.

Additionally, Luxembourg’s government bond market is relatively much smaller and less liquid compared to larger euro area countries like Germany or France. During times of market stress or increased risk aversion, investors tend to prefer more liquid markets.

This preference may have contributed to a wider yield spread for Luxembourg as demand shifted towards more liquid bonds.

Yield spreads widening

While the reasons for yield spread movements can be complex and multifaceted, a similar trend of widening yield spreads has persisted since mid-2021.

Monthly data from Luxembourg’s central bank (BCL) reveals that yield spreads with neighboring countries Germany, France, and Belgium, as well as that with the Netherlands and Ireland have reached all-time highs since mid-2010, indicating a common trend.

Potential consequences

The widening of the sovereign bond yield spreads has significant implications for Luxembourg’s borrowing costs.

It means that when issuing new government bonds or refinancing existing ones, Luxembourg would face higher expenses. As the yield spread expands, investors demand higher interest rates to offset the perceived increase in risk associated with Luxembourg’s debt.

However, a spokesperson for the ministry of finance told Delano on Monday that “due to the overall limited volume of Luxembourg sovereign debt outstanding (€19.27bn), and so far rather irregular issuances, the secondary market for Luxembourg government bonds is somewhat lacking a complete yield curve”, and “thus cannot be directly compared with these (other euro area sovereign issuers).”

In February 2023, Luxembourg issued a €3bn bond, a portion of which will be utilised to repay the €2bn bond that was issued in 2013 and is due to mature on 10 July 2023.

The spokesperson also confirmed that the government currently has no plans for an additional issuance this year.

Since no further bonds will mature before October 2024, there is “no need to plan for any refinancing at this point in time”,  reassured the spokesperson.

However, even if there is no need for new bonds or refinancing, the broader yield spreads could potentially lead investors to shift their investments from Luxembourg to countries perceived as having lower risk, such as Germany. This, in turn, may result in capital outflows from Luxembourg, although the actual impact will only become evident with time.

According to the , the average weighted rate of Luxembourg’s government debt stands at 1.59% as of 30 April 2023.

“Given the rise of interest rates, Luxembourg’s cost of debt will rise in the years to come, as will be the case for basically every other country as well. This has been factored into the budget projections accordingly”, added the ministry spokesperson.

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