Mutualisation of sovereign credit risk key theme to play out, says Axa IM’s Chris Iggo

Chris Iggo, CIO Fixed Income at Axa IM, says one of the key questions facing investors is the extent to which spreads on debt issued by eurozone member states can narrow.

Convergence encore

Let me first wish you all a very happy new year. I hope that 2013 will be a healthy and prosperous one. It has certainly started on a strong footing with equity markets up and credit spreads continuing to narrow. One of the major trends in the bond market has been the decline in the spreads between European peripheral and German government bonds. This trend began last summer when Mario Draghi promised to do whatever it would take to save the euro. That triggered a major turnaround in the market as spreads began to fall from the elevated levels they reached following the crisis in the early summer of last year when it looked as though Greece would leave the euro and thus prove that monetary union was not irrevocable. Markets have moved a long way since then, the “tail-risk” of euro break-up has all but disappeared and investment flows back into peripheral debt markets have been impressive. So now a huge question for investors is how far can this spread narrowing go?

Back to the future

A similar narrowing of spreads happened in the run up to the creation of the single currency and the launch of Economic and Monetary Union in 1999. During that period spreads narrowed until there was virtually no difference between yields on, for example, Italian debt and German debt. Today yields are still very different, although closer to each other than they were this time last year. At the 10-year maturity, Italian government bonds still yield 2.6% more than German bonds, and Spanish government bonds are still 3.38% higher. Current market trends and investment flows suggest that there is an expectation that history will repeat itself and spreads will continue to narrow, meaning that Italian yields could fall by another 200-240 basis points and Spanish yields by up to 300bps relative to German yields. In light of the debt crisis of the last two years and the significant deterioration in fiscal balances and debt sustainability, we need to ask whether conditions are moving in the right direction in Europe to allow a re-convergence of these spreads, or whether investors are crowding into a high risk trade.

Goodbye monetary sovereignty

The initial convergence of European spreads was driven by the strong commitment of European countries to a pooling of monetary sovereignty. The creation of the single currency and the European Central Bank was a mutualisation of currency, interest rate and inflation risk. After a rocky period in 1992-93 a renewed commitment to joining the Euro saw spreads converge rapidly as investors took the view that there would be no currency risk associated with investing within the Euro Area – so French investors could buy Italian bonds and receive a higher yield without taking the risk of currency devaluation. It worked and spreads moved towards zero. The first phase of EMU led to convergence because countries gave up monetary policy sovereignty. To put it harshly, they gave up the ability to get themselves out of economic difficulties by devaluing their currencies (either by inflating or actual currency depreciation). National monetary sovereignty was replaced by mutualised monetary sovereignty in the form of the ECB, mandated to control inflation and support the value of the euro.

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