Spanish Bond Yields Fall, 2 Year Below 6%

Spanish bonds rallied and yields fell on comments from ECB President Mario Draghi indicating that the ECB is ready to act further. Investors took this as a sign that the bank is ready to start buying bonds of peripheral nations that disrupt the "efficient transmission of monetary policy," as former ECB-Governor Lorenzo Bini-Smaghi wrote in the Financial Times earlier this week.

Notably the 2-year bond yield of Spain fell an astounding 11.3 percent early Thursday to 5.7 percent, well below the highs over 7 percent witnessed just two days ago. Investors await the ECB's meeting next week for further clarity on the policy actions that the ECB is to take, but should the ECB buy bonds, it may target shorter maturity bonds rather than longer-maturity ones.

Bond traders should be familiar with the concept of duration, a measure of the risk in a bond due to its maturity. Longer maturity bonds generally have longer maturities, but the measure also takes into account other metrics such as yields. Thus, to limit its duration risk, the ECB could target shooter-maturity bonds and hope that the market drives down yields of longer-term bonds in sympathy.

Capping yields on short-term bonds also helps to prevent a solvency crisis. It is apparent that many peripheral European nations are having liquidity crises, as it becomes more and more difficult to refinance on the long end of the curve due to high yields. However, a solvency crisis would be marked by a sharp rise in short-term borrowing costs. Preventing a solvency crisis would allow a nation, in this case Spain, to continually roll over short term debt so long as yields stay low. In this scenario, Spain will simply be able to muddle through until finances improve.

For more on Mario Draghi's comments, read here.