At the start of the new decade a number of respected commentators are recommending that investors cut back on government debt holdings ahead of an expected deluge of supply. How are markets distinguishing between the creditworthiness of the major sovereign debt issuers?

According to Bloomberg, Pimco, the world’s largest bond fund manager, has cut back on its holdings of US and UK government debt as a precautionary move. Another strategist, Andrew Smithers, was quoted on the FT Alphaville site just before Christmas as saying that he “can see no reason for investors to hold bonds”.

While a bearish view on government bonds may be motivated by the belief that we are at the bottom of the inflation and interest rate cycle, from which the only way is up, concerns about sovereign creditworthiness may also be increasingly important. During the last few years the development of the sovereign credit default swap (CDS) market has enabled investors to “see through” the currency and interest rate components of bond yields and compare issuers’ creditworthiness on a like-for-like basis. What is this market telling us?

One of the key market trends in 2009 was the decline in corporate bond credit spreads from a peak reached in March. This fall in spreads led to handsome returns for anyone invested in company bonds during the period.

Yet part of the improvement in corporate creditworthiness came as the result of explicit or implicit government backstops. While these were provided most visibly to the financial sector (through schemes such as the Troubled Asset Relief Program or “TARP” in the US), the aid schemes helped to reduce fears of default for financial and non-financial issuers alike.

Nothing comes for free, however, and one of the net results of government aid programmes is that some of the reduction in default risk concerns amongst private sector issuers has been “paid for” by a rise in sovereign credit spreads. This has been particularly evident in recent weeks.

The trend of rising government and declining corporate risk can be seen in the chart below, which plots the Markit iTraxx Europe index spread and the spread on the Markit iTraxx SovX Western Europe index. The iTraxx Europe index is an unweighted average of the 125 most liquid investment grade issuers’ five-year CDS spreads, while the iTraxx SovX Western Europe index is an unweighted average of the 15 major European sovereign debt issuers.

As is evident from the chart, the average credit default swap spread on European government debt is now close to that of the region’s major investment-grade issuers (70 vs. 72 basis points, respectively, as at 4 January, according to Markit). Only three months ago, on 2 October, the iTraxx Europe index traded at 99 basis points, while the SovX Western Europe index was nearly 50% lower, at 52 basis points.

It’s important to remember, say credit market specialists, that sovereign and corporate CDS spreads are not entirely equivalent. For a start, the definition of a credit event (which would trigger a payout under the contract) differs slightly when governments are issuers (“failure to pay” and “restructuring” are credit events for both corporate and sovereign issuers, while corporates typically have “bankruptcy” as the third credit event, and sovereigns have “repudiation/moratorium” as theirs). Also worth noting is that the Markit iTraxx SovX Western Europe index has been available in tradable format only since late September, prior to which index levels have been calculated on a theoretical basis.

Nevertheless, the trends in the chart are clear.

On a country-by-country basis, which government issuers have been primarily responsible for the recent widening trend in European sovereign credit spreads?

Specialist credit market data analyst CMA has provided the following chart, which shows the CDS spreads of 12 leading European government issuers since the beginning of the fourth quarter (when sovereign credit spreads started to rise).

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