Invest in German Government Bonds in 2023

Last updated on 12 de March de 2023

Commonly referred to as Bunds, German governments bonds are the safe haven asset when it comes to Euro-denominated investments. We analyze what they are, advantages, disadvantages, and how to invest in German government bonds.

What are German Government Bonds?

German government bonds are debt instruments issued by the federal government in Germany. They are considered the safest among all countries in the Eurozone.

Because of that, investors treat German government bonds as though they had no credit risk. They are the equivalent of US Treasuries in the Eurozone.

This is because Germany is the largest economy in the bloc. It is also one of the most prosperous and fiscally stable. And monetary policy from the European Central Bank is heavily influenced by German officials and economists.

German government bonds are often referred to as Bunds. Bunds is short for Bundesanleihen (German for federal bonds).

It is possible to invest in German government bonds with maturities ranging from 1 month to 30 years. As such, they are great instruments to either keep dry powder in our portfolio or take long term bets related to interest rates and the state of the economy in the future.

German state and municipal governments also issue their own bonds, and those are available to invest too. However, they are much less liquid and exposed to some credit risk. Therefore, we focus our discussion on bonds issued by the central government.

Advantages

The most important advantages of investing in German government bonds are the following:

No Credit Risk

The German government is considered what of the most creditworthy institutions. This means the actual risk of the German government defaulting on its debts is virtually zero.

Germany’s public finances are in a relatively good state. It is one of the very few governments in both the Eurozone and the world that still receives a AAA credit rating by all three main ratings agencies.

Governments of other countries, such as the United States, the United Kingdom, Japan or France have long lost either their AAA rating from either one or all three ratings agencies.

The traumatic hyperinflation experienced in Germany in the early 1920s, which wiped out everyone’s savings and led to the political catastrophe of the 1930s, made Germany very concerned about inflation and debt.

Additionally, Germany is also the country exerts the most control over the monetary policy set by the ECB. As a result, if Germany’s public finances deteriorated in the future, central bank policy would most likely turn accommodating to help Germany out.

No Currency Risk for Eurozone investors

German governments bonds are denominated in Euros. Prior to the introduction of the Euro, they were denominated in Deutschmark, which was one of the strongest currencies of the second half of the 20^th century.

Nowadays, German government bonds offer a way for all Eurozone investors to invest in very safe bonds without having to take on any currency risk.

Currency risk is the risk of exchange rates moving against us in the future. For example, US investors can invest in German government bonds and take on currency risk. The exchange rate between the Euro and the US Dollar would determine the profitability of that investment.

This would be the case unless the US investor has hedged the currency risk, which is both possible and available to all investors.

On top of that, if the Eurozone were to break up in the future and all government bonds redenominated in their new national currencies, it is very likely that the new German currency would significantly appreciate against most other currencies.

Diversification

Diversification is one of the main reasons we may want to invest in German government bonds. Their returns are likely to be uncorrelated with those of other riskier asset classes.

If we have a significant portion of our investment portfolio invested in the stock market or in real estate, we are heavily exposed to several macroeconomic risks. These include recessions, deflation or even a credit crunch.

In such scenarios, German bonds would probably increase in price. This is because many investors would seek refuge in safe haven assets and bid them up. Additionally, interest rates may be lowered at that point, making our bonds worth more.

Liquidity

German government bonds tend to be the most liquid in the Eurozone. We can buy and sell easily, with large quantities, and at very narrow bid-ask spreads.

This means we can buy and sell them at almost the same price. This is in contrast with the government bonds of other major Eurozone countries, for which we would have to pay higher prices to buy than we would receive if we sold them.

Disadvantages

Let us discuss the main disadvantage of investing in German government bonds:

Low Real Interest Rates

Even though interest rates increased dramatically in 2022, German government bonds still offer moderate yields that are lower than the inflation rate.

While we can make the case for inflation coming down in the future, which would make 2023 interest rates on German government bonds very attractive, this is no certainty.

Consequently, how good interest rates are will very much depend on what happens with inflation in the future.

If inflation does go down again or there is a recessionary deflation, German government bonds would rally significantly. Especially long-term bonds, as they offer the most duration exposure.

Inflation Risk

As we have just discussed, the yields we see in 2023 for German government bonds are very modest and still below the official inflation rate.

Inflation is always a risk for bonds and cash because it makes us lose purchasing power. Therefore, it is advisable to combine government bonds with other assets in our portfolio that can withstand inflation better.

If inflation is our biggest worry, yet we want to invest in German government bonds, we also have the option to buy inflation-linked German government bonds. The value of these bonds will increase in line with inflation, thereby completely hedging the inflation risk. You can read more about inflation-linked bonds here:
Inflation-Linked Bonds – What They Are and How They Work

The other reason why elevated inflation is worrying is because it tends to lead to a rise in interest rates, as we discuss next.

Risk of Rising Interest Rates

Rising interest rates are like kryptonite to bonds. Especially long-term bonds.

When interest rates go up, bond prices go down. This is because our old bonds, which pay much lower interest rates, become less attractive than the new bonds being issued which offer much higher yields.

This makes old bonds worth less and their prices plummet. This is what we saw in most developed countries in 2022. With rising interest rates, government bond prices collapsed.

Even though yields in 2023 are very high compared to where they have been since 2008, it is possible for them to go up further, especially if inflation proves persistent.

How to Invest in German Government Bonds

Let us see the different ways in which any investor can invest in German government bonds:

Exchange-Traded Funds (ETF)

One of the easiest ways to invest in German government bonds is through an ETF. Bond ETFs can be bough and sold very much like any stock or equity index fund.

Bond ETFs are usually incredibly liquid, easy to trade, quoted in multiple currencies, and available in small denominations.

These ETFs replicate bond indices composed of German government bonds and offer a great amount of flexibility. We do not need to invest in all German bonds. We can choose what type of bonds we want.

Some ETFs invest in German bonds of all existing maturities (from 1 month to 30 years), such as the iShares Germany Govt Bond UCITS ETF, managed by Blackrock.

But Blackrock and many other ETF providers also offer funds that invest solely in bonds of certain maturities. For example, if we want to invest in short maturity bonds, we will look for an ETF investing in bonds with maturities between 0-1, 0-3 or 1-3 years.

Conversely, if we want a macroeconomic hedge against a deflationary recession and are looking for long maturity bonds, we can look for an ETF that invests in bonds with maturities between 20-30 or even 25-30 years.

The longer the maturity, the greater diversification, the higher the interest rates, and the better the macroeconomic hedge, but also the greater the risk of both inflation and rising interest rates.

Another very attractive feature of investing in German government bonds through an ETF is that we can find currency-hedged versions. For example, if a US investor wants to invest in these bonds without taking on the risk of the Euro going down, we can look for a German government bond ETF hedged into USD.

Directly from our Broker or Bank

Finally, we also have the possibility to buy a German government bond directly. Many brokers and banks offer this option. This is what gives us the most flexibility in managing our portfolio. We simply need to select which bond we want to buy and how much.

Interactive Brokers is one of those brokers that allow clients to invest in German government bonds directly. This can be done in increments of €1,000.

If we want to invest in German government bonds with a maturity of around 7 years, there is an important difference between buying a bond directly or an ETF with a specific maturity.

If we buy a bond with a maturity of 7 years and keep it in our portfolio, we will have a 4-year bond 3 years later. And if we hold that bond until maturity, we will receive our cash from the German government and have to reinvest that money.

Conversely, if we buy an ETF investing in German government bonds with maturities ranging between 5 and 7 years, bonds will enter and exit the ETF. When a bond’s maturity drops below 5 years, it will be dropped. And when a bond’s maturity drops below 7 years, it will be bought by the ETF.

The bond ETF will be rebalanced on a regular basis to stay in that specific duration range. As a result, if you plan to hold those bonds for long, you need to be aware of the differences between buying individual bonds and ETFs of specific maturities.

Investment Funds

Finally, another option to invest in German bonds would be to fund a fixed income mutual fund that focuses on this segment of the market. These funds are also known as active funds.

In this case, instead of choosing which types of bonds we want to invest in ourselves, the fund manager would take care of it.

This means we would have less control over our investment. The macroeconomic views of the fund manager would determine how the fund is managed.

Something to bear in mind is that these traditional investment funds tend to have higher management fees than ETFs. This is because a team is actively managing them.

Conclusion

Investing in German government bonds can provide our portfolio with a great amount of diversification and hedge against adverse macroeconomic events. As such, it can significantly cushion our returns if markets are difficult.

At the same time, while they do not offer the highest interest rates, they still pay us something just to hold them. We can say that it is a hedge that pays us to own it. But remember it also has its own risks.

Like with any other asset, they need to be analyzed in the context of our entire portfolio and what the future can bring us.

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And if you want to learn more about how bonds work, check out this guide:
Introduction to Fixed Income