Sovereign versus corporate bonds credit spreads in Europe

Abstract

The sudden detection in the year 2010 that fiscal deficits and debt burdens in the Eurozone had grown beyond sustainable levels brought investors to look at corporate bonds as a refuge from the peripheral European sovereign bond market. Attention was directed towards highly indebted Eurozone countries, with Greece at the centre of the crisis that spread also to Ireland, Spain, Portugal and Italy. At the same time, the European corporate sector was assigned a fairly favourably credit outlook as default rates fell below their long term run rate, whilst, earnings growth remained strong, with large cash positions on the balance sheet. This led to European corporate bonds to trade at narrow credit spreads compared to their respective governments and in some cases the yields on these corporate bonds traded below the comparable government bond. Through an analysis of the European bond market since the introduction of the Euro, this dissertation will evaluate the recent credit spread compression by utilising Merrill Lynch Indices and will attempt to compare the economic factors behind such yield compression in the respective market cycles. The analysis will conclude by evaluating the economic forecasts for the Eurozone to determine whether this phenomenon is likely to remain in place in the near future as corporate bonds continue to be regarded as safer investment choice.