The sky’s the limit in Europe.

The Financial Times’ blog, FTAlphaville, has a recurring feature titled “This is nuts. When’s the crash?” The feature has often focused on Chinese stock valuations, but another favorite subject is European bond yields.

mr-peanut-plantersSeriously, they’re nuts. And that should raise flags for anyone considering a world bond fund.

Bonds are IOUs that make regular interest payments. If you’re an investor, your main interest is getting paid interest when you’re supposed to, and getting your principal back. If you’re very confident about your borrower, you charge them a low interest rate. If you’re worried about getting paid back, you charge a high interest rate.

So it makes some sense that Greek 10-year bonds pay 12.6% annual interest. There may be people who believe that Greece won’t default, but they probably get that information from the radio signals in their teeth.

And it also makes some sense that Germany’s 10-year bond yield is 0.79%. The country has a solid AAA credit rating, and German inflation is lower than the Mariana Trench.

Once we get beyond Greece and Germany, things get odder. Take Italy, for example, which has the world’s third-largest bond market, behind the U.S. and Japan. Italy has a BBB-, which is considered “lower medium grade,” about ten notches below Germany. Italy’s bond yields 2.32%, or 0.03 percentage points lower than the U.S. 10-year Treasury note, which is also a AAA credit.*

Then there’s Spain, which, until recently, was also teetering on the brink of default. It’s 10-year yield is 2.34%, one-one hundredth of a percentage point lower than the U.S. Ireland’s 10-year note. Its credit rating: BBB, one notch above Italy’s, and nine below the U.S.

Bond yields take into account more than credit ratings, such as the outlook for inflation and the country’s national debt. And Spain and Italy have shored up their finances, to some extent. But bear in mind that Spain’s 10-year note touched 8% when the Greek crisis first began, and that Italy’s crested just shy of 8%. While there’s plenty of upside to yields worldwide, the sky’s the limit in Europe.

And that’s a problem if you own international bonds, because bond prices fall when interest rates rise. If your fund owns German bonds, a 0.79% yield isn’t going to cushion you from much pain. Making matters worse: If the dollar rises in value, you’ll lose on the currency translation, too. Currently, world bond funds are down an average 2.11% this year, according to Morningstar. Things are likely to get worse before they get much better.

* Ok, S&P gives us an AA+ rating. But Fitch and Moody’s go with AAA.

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