Despite the Eurozone experiencing a drastic inflation, energy and terms of trade crisis, the European Central Bank (ECB) is having to hike rates. This presents capital markets with sovereign and credit spread risks, as well as possible fragmentation risks as intra-European sovereign spreads widen. Bond investors aiming to limit credit risk should note the policy support in European sovereigns, while remaining vigilant in high-yield corporate credit.

European yields and sovereign spreads

European yields and sovereign spreads from 2011 to the present

Bloomberg, Principal Global Investors. Data as of September 14, 2022.

Investor sentiment towards European risk assets is unambiguously negative, with equities valuations discounted, Germany’s terms of trade falling to 30-year lows, and natural gas prices surpassing the equivalent of $575/bbl of crude oil.

With the ECB introducing rate lift-off in August, and recently enacting the largest rate hike since its founding, corporate credit spreads have resumed widening. Sovereign spreads between core and periphery countries have also widened, but by less, reflecting proactive ECB actions.

Indeed, the ECB is alert to systemic risks posed by sovereign spread widening1, as it raises so-called “fragmentation risks,” and could interfere with ECB policy transmission. Consequently, the central bank has been actively deploying its Pandemic Emergency Purchase Programme (PEPP) funds to contain such widening. In July, the ECB reduced its holdings of core sovereigns by nearly €19bn, and reallocated a majority to periphery sovereigns. In so doing, the ECB has permitted core bond yields to rise but limited the increase in peripheral yields.

Investor hesitancy toward European fixed income is justified for now, as uncertainties remain with the geopolitics of Ukraine, risks of a cold winter, and upcoming Italian elections. However, the safety of central bank support in some sovereign bonds is noteworthy for investors looking to limit credit risk, as corporate credit is unlikely to garner similar support from a historically hawkish monetary authority.

1 Sovereign spreads are the difference in market interest rate on two European sovereign bonds of equal tenor or maturity. Specifically of focus at the ECB is Core bonds, like Germany, versus periphery countries, like Italy.


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