Carlo Palin

Corporate credit investors are scrambling to get to grips with sovereign exposure as even apparently healthy companies’ bonds succumb to contagion, finds Lynn Strongin Dodds. In the not too distant past, Europe was divided neatly into the ‘core’ countries and the ‘peripherals’. Today, the distinctions are less clear, as the euro-zone debt crisis infects Europe’s bluest chips, regardless of location. Although the spreads are still wider for those at the rim, investors are advised to look much more carefully at sovereign risk when analysing the corporate fundamentals. Overall, euro-denominated bonds of European companies in November turned in their worst performance as the crisis intensified. In the derivatives market, the iTraxx Europe Main index of credit default swaps (CDS) on European investment-grade bonds rose to 209 basis points (bps) in November, close to the record 216bps touched in December 2009 (although the Crossover high-yield CDS index is still far from its financial-crisis peaks). Peripherals are only a small contingency of the 125-member iTraxx Europe. It does not contain any Greek, Irish or Portuguese borrowers, while Spain and Italy together account for just 12.8% of its constituents. However, despite their minority position, they are having a disproportionate impact on a corporate world that had been in relatively good health. “What we are seeing now are signs of weakness in company quarterly earnings and slowing demand, led by the peripheral countries,” says Richard Phelan, head of European credit research at Deutsche Bank. “This has been brought on by the austerity measures taken by these countries and it is causing concern for the credit quality of all companies that issue bonds. The big question is what the impact of the euro-zone crisis will be for default rates, which have been low.” For now, fund managers are not re-drawing their European investment maps. “[But] it is all getting slightly blurred,” says Bill Street, global head of active fixed income at State Street Global Advisors. “About 18 months ago it was much more clear-cut. We categorised Europe in three tiers. The first was Northern Europe, France and Germany, followed by Spain and Italy in the second tier, as they were seen as being more stable. Greece, Portugal and Ireland were in the third. However, the volatility of the sovereign spreads is being driven up all the way to the core.” Duncan Sankey, head of credit research at