The Wilder View

Linking Sovereign Risk to Corporate Credit Spreads in Europe

Financial firms in Europe and the US are hitting crisis mode, as illustrated by relative borrowing costs, spreads, to comparable government bonds (see financial spreads chart to left and click to enlarge). World policy leaders anxiously await – and some promise to deliver – a solution to the euro area sovereign debt crisis at the IMF annual meetings. Tim Geithner urges policy makers in Europe to end the “threat of cascading default, bank runs and catastrophic risk”. We really are in crisis mode.

However, in order for Europe to end the threat of bank runs and catastrophic risk, they must address the cause of the banking crisis itself. Wherein lies the risk to the European banking system? Is it liquidity? Is it solvency? What does the ‘market’ think? In this post (and in a subsequent post as well), I’ll highlight the following point: at this time, there is no liquidity crisis, per se, in the European banking system – there could be in coming months/quarters if deposits fall more sharply. The underlying risk to the banks is their sovereign exposure, as illustrated by the sector-level breakdown of European corporate credit spreads.

The coordination of the European national governments is failing, inherently disintegrating any implicit guarantees in the banking system. Therefore, the risk premium is rising.

As a point of reference, the chart below illustrates the US investment-grade corporate credit spread, according to the Barclays Capital corporate credit indices, and broken down by broad industry: financials, industrials, and utilities. Industrial and utility firms are outperforming financial firms in the US, as negative bank headlines and ratings downgrades weigh in on the risk premium of the US’ largest financial institutions. In fact, industrial and utility firms are holding in rather well despite significant downside risks to the economic outlook. These are more defensive industries.

In contrast, while European financials lead the way in the risk sell-off across Europe, so too are utility borrowing costs relative to industrials. This relationship is in stark contrast of the 5-year historical performance, where spreads on utility corporate debt is lower than that of industrial spreads.

The chart below illustrates the same credit spread for European investment-grade corporates broken down by broad sector. I’ve included the current underperformance of sector spreads compared to their 5-year historical averages in the legend: industrials off 57%, financials off 110% and utilities off 131%. In this light, utility firms are the worst performer overall.

In many cases across Europe, the sovereign either owns part of and/or explicitly guarantees the utility firm. Take the corporate Enel, for example. This is a multinational Italian utility firm, a firm that should trade rather defensively, given its exposure outside of Italy, it’s A- rating, and defensive sector. However, the sovereign owns 13.9% of the firm – a backstop of capital that is increasingly coming into question. Therefore, markets are repricing the risk of default by Enel, given that its explicit guarantor, the Italian Ministry of Finance, is burdened by surging borrowing costs and rollover risk of its own.

And herein lies the answer to what the market perceives as the biggest risk in Europe: it’s sovereign risk that’s dragging European financials, as demonstrated by the sharp sell-off in European utility industries. It’s the lack of credible sovereign backstop that worries bond investors, since implicit guarantees go a long way in bond market pricing (I’ll address liquidity in a sequential post).

3 Responses to “Linking Sovereign Risk to Corporate Credit Spreads in Europe”

S. SelimSeptember 26th, 2011 at 12:33 am

What has stopped the ECB from buying unlimited quantities of sovereign debt is that:

1. They've already gunked up their balance sheets with 100's of billions of euro periphery debt via both (a) direct purchases of PIIGS sovereign debt (Italian and Spanish mostly), (b) accepting PIIGS sovereign debt as collateral for unlimited liquidity provision to those countries' banks (as they banks have lost market access).

2. Any more direct purchases than what they've already bought would take the ECB's current role from temporary "stabilization" to permanent backstop – which would imply explicit monetization of illiquid (and in Greece's case, insolvent) countries' debt. Monetization of debt amounts to the ECB funding the fiscal activities of eurozone countries; this is problematic because it is (a) wildly unpopular/vehemently opposed by the German public as well as the Bundesbank, and (b) illegal under the treaty establishing the ECB which specifically prohibits the ECB from underwriting the fiscal activities of eurozone governments.

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