Moral Hazard and the Corporate fixed income market

As shown by this chart (courtesy of Zero Hedge), European sovereign spreads measured by the Markit iTraxx SovX Western Europe Index have risen higher than corporate iTraxx indexes for the first time in history, reflecting growing fears of a sovereign default tail risk in 2010.

First, the analysis requires mentioning that the geographical composition of both indexes differs.

As described by Markit, the SovX indexes include:

• Markit iTraxx SovX G7 – tracking the credit risk of the most industrialised countries in the world.
• Markit iTraxx SovX Global Liquid IG – tracking the credit risk of countries in Asia Pacific, Eastern Europe, Latin America, Middle East & Africa, North America and Western Europe.
• Markit iTraxx SovX Western Europe – tracking the credit risk of 15 countries in Western Europe.
• Markit iTraxx SovX CEEMEA – tracking the credit risk of 15 countries in the CEEMEA region.

If the breakdown of the corporate index is not disclosed, the inversion of the curve would not be witnessed were both indices to be trade-weighted in the same way.

Second, the limited lifespan of the European SovX index must be discounted, the index having been opened to trading only since September 2008.

However, the spread between the Sovx and Corporate indexes stands at a record-low level and even turns negative without the geographical distinction.
On the one hand, debt-laden governments face increasing doubts from investors regarding their ability to fund both previous and upcoming fiscal stimuli. We distinguish two premia drivers depending on country monetary independence:

• Fiat currency countries: Being able to use quantitative easing strategies to inflate out of their debt, there is low tail risk these countries will default. In these countries, spreads are driven primarily by inflation expectations.  
• Countries with no/low monetary indepence: as it is the case for Greece, increasing CDS spread are driven by default risk perceptions. 

On the other hand, corporate spreads are driven lower by develeraging and a global improvement in corporate cash flow generation. There is little doubt investors also consider central bank interventions will be led were corporate default risk to appear. The sheer definition of moral hazard.


As a result of these trends, credit default swaps spreads between European sovereigns (equally weighted) and the European investment grade credit universe have significantly tightened.

This news comes as corporate bonds issuance and subscriptions reach record levels, suggesting that Q1 2010 could provide credit markets with a 2009-type windfall.
On the sovereign side, the yield curve between 10y and 2y has reached the 288 basis point record mark, reflecting growing anticipation the FED will hike rates sooner than expected.


Were central banks to move towards interest rate raising, the trend on corporate bonds yield will reverse as bond price go down. As seen on the chart, the corporate itraxx has retraced its Lehman related increase and has been range bound during the last 2 months.


As the spread between government bonds and high investment grade corporate bonds closes to 0, investors will increasingly shift to riskier positions.