The eurozone crisis is doing to sovereign debt what the Lehman Brothers bankruptcy did to corporate debt — highlighting developed markets' credit risks that were previously ignored.
Contagion fears emanating from Greece have again roiled global markets as Italian 10-year bond yields shot above the 7% investors' psychological danger zone on Nov. 9 before the European Central Bank stepped in to buy Italian debt in a bid to lower borrowing costs; the Italian bond yield fell to 6.45% on Nov. 11. So far this year, the spread between peripheral European sovereign bonds and the benchmark German bunds has reached record levels as money managers and others continue to flee bonds issued by Greece, Ireland, Portugal, Spain and Italy. France is also under pressure, as the France/Germany yield spread for 10-year bonds stood at around 160 basis points on Nov. 11 compared to about 40 basis points at the end of last year.
The 2008 collapse of Lehman Brothers Holdings Inc. brought “a degree of change in the way investors evaluate corporate securities,” said Paul Cavalier, partner and global head of fixed-income manager research at Mercer LLC in London. “We now think very differently about how to quantify corporate credit risk. This is similar to what's happening in the sovereign debt market” as a result of the uncertainty in the eurozone.
“Investments in government bonds used to be a "sleep-easy-at-night' product. Over the past several years, many managers are realizing that the analysis for this asset class requires a lot more details, both in terms of risk and alpha potential,” Mr. Cavalier added.
Scott Thiel, London-based managing director and deputy chief investment officer of fundamental fixed income at BlackRock Inc., noted there has been increasing emphasis on credit risk in sovereign bonds, particularly within the eurozone.
“This is a fundamental shift,” Mr. Thiel said. “Investors look for two things from government bonds: liquidity and surety of principal. When those two reasons become questionable — the second in particular — the credit analysis process has to be reinvigorated. ... Credit risks have become much more important.”
“In the old world, you had the G-10 countries driven by (exposure to) interest rate risk, and below that, you had the emerging markets with credit rate risk,” said Andrew Balls, managing director and head of European portfolio management at Pacific Investment Management Co. LLC based in London. “In the world we live in now, if we look at Portugal vs. Brazil, Brazil has much higher credit and a much stronger balance sheet. Investors are demanding a higher yield to hold (debt issued by) Greece than Pakistan. We can make similar comparisons for Ireland and Mexico, and so on.”