Euro Credit Returns Could Be Wiped Out in Just a Few Days

  • Ratings-adjusted credit spreads even closer to record lows
  • Investors could see big losses if spreads move by a whisker

The voracious appetite for risk in European debt markets is even greater than already-tight credit spreads suggest.

The “Goldilocks” rally -- low volatility, corporate profit growth, cheap capital -- has spurred risky bets to levels not seen since the height of the credit bubble a decade ago. The credit quality of bonds today is more fragile relative to the pre-crisis peak, thanks to relentless monetary stimulus that has triggered a boom in lower-rated investment-grade issuance.

In European debt markets, the rush to risk is even more aggressive than indexes might suggest. That leaves investors vulnerable to outsize losses if spreads move by a whisker.

Take the iBoxx index for corporate bonds in euros. The index spread has tightened by over 100 basis points from February 2016 -- to just 21 basis points wider than 2007’s record low -- amid the upturn in the euro-area’s economy. Does that suggest investors are demanding more compensation for credit risk in euros today relative to 2007? Barely.

Re-weighting the current index to match the credit-rating profile of 2007 suggests spreads are just nine basis points shy of the all-time low, according to Joseph Faith, credit strategist at Citigroup Inc. in London. In other words, European credit markets are much closer to record lows than a straight comparison of the index spread relative to the pre-crisis peak would suggest.

From a ratings-adjusted perspective, the excess return offered by European investment-grade bonds over the government benchmark would equate to a paltry 50 basis points, according to Faith. 

That “could easily be wiped out with a few days of spread widening,” he told Bloomberg News via email. “From a European credit perspective, my answer to the question of how much further we are likely to go if market exuberance returns to its pre-crisis peak is ‘not much.”’

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