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By Sandrine Soubeyran, Director Research & Analytics, FTSE Russell
Evidence of growing concerns over high inflation, rate hikes and central banks withdrawing their asset purchasing support programmes has been particularly visible in European bond markets.
For corporate bonds, this can be observed by looking at the spreads of European investment grade and high yield bonds versus German 7-10yr government bonds. As Chart 1 shows, after their initial spikes in March 2020 from the coronavirus shock, the spreads of European investment grade and high yield credits significantly compressed as central banks implemented broad QE programmes (including for the sub-IG high yield sector) and interest rate cuts to ease financial conditions. Despite the deteriorating economic outlook, they remained stable during much of the pandemic. However, as economic growth started to improve with the lifting of lockdowns, corporate bond markets became increasingly nervous by the prospect of the unravelling of easing policies, and supply chain disruptions and rising energy prices stoking inflation. This caused spreads to widen in the last months of 2021 and into 2022.
The back-up in yields was most noticeable in February 2022, when general risk-off sentiment over the tensions in Europe, which were escalating throughout February, affected risk assets, particularly in sub-IG credits, whose sell-off mostly mirrored that of European equity markets. European high yield credit posted a negative return of 3% in euro terms, compared to a loss of 1.1% for their US high yield equivalents, while the FTSE Europe ex UK declined by 5.4%.
However, the back-up in yield did not just affect corporate bonds
Similarly to their corporate bond equivalents, peripheral European government bonds have also seen their yields rise sharply. But the story here may have a further dimension. Using Italy as a case in point, the EU’s phasing out of its Pandemic Emergency Purchase Programme (PEPP) in March 2022 combined with anticipated rates hikes have also revived sovereign credit fears.
Let’s recall 2018. European markets were really spooked when the EU had placed Italy on its watch list of countries for not complying with its debt reduction programme to correct excessive public debt burdens. Italian 10-year government bond (BTPs) yields rose sharply during this period (and more so than their Spanish equivalents), with their spreads vs 7-10yr Bunds widening to near 315bps (Chart 3). The EU’s Stability and Growth Pact says that a state’s budget deficit cannot exceed 3% of GDP and its national debt cannot surpass 60% of GDP. Italy’s debt per GDP of around 135% had reached one of the highest levels within the Eurozone. At the same time, the lack of progress in forming a stable coalition government added fuel to fire. Eventually, EU support and improving economic growth calmed markets.
Similarly in March 2020, BTP vs Bund spreads spiked up to reach 280bp (Chart 3) during the initial Covid-19 shock. The EU responded in March 2020 with PEPP to provide liquidity and ease financial conditions, not for just Italy, but for the whole of the Eurozone. Like for European corporates, the central bank action promptly calmed markets as the 7-10y BTP and Bund spreads contracted within 100bp. However, the size of Italy’s debt per GDP grew to a much higher level of 156% and has stayed at this level since.
Where does this leave us? With the ECB in tightening mode and a historically high debt per GDP level, the question is how long before European investors really notice?
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