The credit crunch started in June 2007 and any official account of it would rival the length of Homer's Iliad in: a) length; and b) the full panoply of human vices laid bare. But what is indisputable is that what was once regarded as safe has turned out to be as secure as the walls of Troy.
Tortured metaphors aside, the bond market, particularly for government debt, used to provide investors with a set of certainties about what would happen in 10 years' time: coupons would be paid and an AAA credit rating was the gold-plated guarantee that more investors would line up and the original debt would be refinanced and your money returned.
Over the past year this simple certainty has crumbled away as countries in Europe reel from a series of bank-inflicted sovereign debt crises. Saving 'too-big-to-fail' institutions might have been necessary to prevent a wholesale collapse in the system, but it has left weaker nations dependent on the whims of an increasingly unsettled global bond market. In short, after two decades of slumber, the 'bond vigilantes' have awoken and are baying for blood.
The sovereign risk
Whatever tack the market decides to take next year, the bailout of Ireland's financial system will go down as an historic event in the history of the single currency; the banking system of a country of 4m people threatened a contagion that could have destroyed a project 50 years in the making.
The E85bn (£71.3bn) bailout was initially cautiously received but the problem for bond market watchers is that it is almost impossible to distinguish between sovereign debt in some countries and those of their banks. Ireland is a case in point: E35bn of the total bailout money will be used to recapitalise the banks and keep liquidity in the system.
And the Irish aren't the only ones. Spanish and Portuguese banks are heavily reliant on special liquidity funding arrangements agreed with the European Central Bank. What is emerging in Europe, according to Blaise Ganguin, chief criteria officer at Standard & Poor's (S&P), is a largely two-tier banking system defined by an individual bank's ease of access to short-term funding. Northern European countries have seen a significant improvement in funding conditions, along with an improvement in asset quality. That said, there are still E500bn of commercial property loans that need to be refinanced by 2015 which could affect individual banks. But, as Mr Ganguin emphasised: "This is the first time that we as a ratings agency have had to measure the default risk on government debt in a way that links it to bank debt."
The plus point for sovereign debt holders is the amount of debt that needs to be refinanced in Europe is high, a total of E10 trillion over the next five years, and it is fairly evenly spread over that time in E2 trillion packets. In addition, the Basel III reform is creating demand from banks and insurers for more liquid capital that can be kept in reserve, so government bonds from fiscally stable countries should not be difficult to sell.
Corporate bonds retain popularity
In contrast to sovereign debt, S&P's data implies a good year for corporate bonds in 2011, especially the higher-yielding type favoured in a time of low interest rates. Default rates have been falling all year and are set to sink below the long-term average of 4.3 per cent. That contrasts with forecasts for a default rate of 8.3 per cent this time last year. S&P reckons a modest fall to 3.8 per cent will continue by the end of next year. The relatively stable economic environment, supported by central banks, meant that more companies further down the credit scale (anything below BBB) were able to finance senior debt without too much difficulty.
Overall, the picture for most types of European debt looks fairly stable next year, but this could change towards the end of the year as the refinancing cycle for 2015 onwards will start again so that debt can be rolled over. That might lead to a small rise in defaults in 2012 in high-yielding bonds.
A further message from the ratings agencies to private investors thinking about buying bonds next year is to pick your sectors carefully. What is unusual about this recovery is that the industries doing best are those that would normally be regarded as heavily cyclical such as chemicals, media & telecoms and capital goods.
What seems to be happening is that these companies have taken advantage of their operational gearing to sell products into emerging markets on the back of historically weak currencies.
Companies could also take increasing advantage of a funding window between now and the middle of 2011 to refinance. Bond sales in December averaged $15bn a week alone.
