Sovereign curve inversions point to double dip, says CDR

Credit Derivatives Research says that its Government Risk Index has risen to over 75bp this week, bringing it close to the spreads (or risk) the market perceives for US and Europe investment grade corporate credits and having a deteriorating impact on public sector recovery. Analysts note that sovereign risk is now over 90% higher than its lows in September 2009 as it reached its highest levels this week since April 2009.

With sovereign risk curves inverting in some names, government bond spreads trading wider than CDS spreads for some, and the steepening of the corporate credit term structure, CDR suspects the shadow of a double-dip is being priced into credit and the efforts of an already economically weakened government may not be enough this time. Sovereign risk among the more developed countries has risen considerably more, in relative terms, than EM sovereigns but some notable peripheral nations such as Greece, Iceland, and Dubai are showing no signs of relief.

The sovereign risk threat most clearly impacts financials, says CDR, since during the crisis balance sheet risk transferred from the private sector to the public sector as governments engaged in globally coincidental bailouts, backstopping, and stimulation. This explicit support for bank capital structures initially spiked sovereign risk (and enabled financial default risk to drop significantly), but the growing uncertainty of a coherent exit strategy among the majors combined with a lack of clarity on austerity measures are starting to be reflected globally in government bonds and implicitly in financial senior and sub debt decompression.

Aggressive voluntary austerity in mainland Europe is being punished more by the markets in the short-term as Spain, Germany, and France are well over 50% riskier in the last month. However, since the September 2009 lows, the picture is different with US, UK, and Japan (on a course of involuntary austerity) up over 95% while Spain, Germany, and France have risen just less than 90%. This adjustment likely reflects the implicit devaluation premia that is inextricably tied to sovereign CDS via the US dollar denomination in non-US risk.

The impact of sovereign risk decompression is being clearly felt across corporate debt markets, with a barbell effect across the credit quality spectrum. Recent anxiety has seen a renewal of the up-in-quality trade with investment grade outperforming high yield, but at the other extreme sovereign risk is leaking over into the lowest spread corporates leaving credits with spreads between 75bp and 300bp (or around double-A to triple-B) in a sweet spot for now.