European Bond Rally May Have Legs

by Richard Barley

Wall Street Journal
February 2, 2012

Credit where credit's due: January was a bumper month for European corporate-bond markets, with euro investment-grade bonds returning 2.9%, according to Barclays Capital. And even now corporate bonds look unloved. Although a yield of 4.2% for five-to-seven-year bonds looks skinny, it is way above yields on German bunds and prices in a lot of risk. Investors should consider buying.

Last year, European corporate debt priced in a deep recession and renewed credit crunch. But the European Central Bank's three-year liquidity injections have staved off the risk of a systemic crisis. Issuance has picked up, and bond sales have been heavily oversubscribed.

Average European corporate-bond spreads have tightened to 2.8 percentage points over government bonds, from 3.3 points at the end of 2011, but they are still far above 2011's tightest level of about 1.6 points. On Tuesday, Italy's Intesa Sanpaolo became the first peripheral bank to sell senior unsecured bonds since July 2011.

But the market is still pricing in disaster. Take the iTraxx Europe index of credit-default swaps on 125 European blue-chip companies, a proxy for corporate-bond spreads: It costs €139,000 ($181,842) a year to insure €10 million of their debt against default for five years. Assuming a recovery rate of 40%, the index is pricing in a five-year default rate of 11.4%, according to Tradeweb.

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