European credit loses ground to US

European credit spent the latter half of last year making up lost ground on its US counterpart, but in recent weeks it has reverted to old habits and retreated.

The differential between the Markit iTraxx Europe and the Markit CDX.NA.IG indices narrowed to 14bps in mid-January, the smallest basis since July 2011. But since then it has widened out and is now 28bps, the largest gap since last November.

Credit markets are complex beasts and there are probably several technical and fundamental factors that influence the basis between the two indices. However, there are a couple of forces that have come to prominence in the first weeks of 2013.

Event risk in the form of leveraged buyouts has returned after lying dormant since 2007. US technology firm Dell was the instigator of the current wave of speculation, and the company finally agreed a deal this week that will take it private.

Given Dell's North American base and the more favourable funding climate in the US - bank balance sheets have been repaired and the CLO market is active again - it might be thought that the rumour mill would focus on potential LBO targets in the US.

There has indeed been some speculation around American companies, particularly in the TMT sector. However, despite the less than ideal funding conditions, there have probably been more rumours and activity in Europe.

Cable operator Virgin Media was acquired by Liberty Global in a leveraged deal, while EE, a UK mobile telecoms provider, is reportedly in talks about going private. Spreads have widened on the prospect of a flood of LBOs, leading to a notable underperformance in TMTs.

So, LBO speculation has probably contributed to European credit lagging behind the US. However, there is another factor that may be playing a bigger role in driving the divergence. Banks have a large weighting in the Markit iTraxx Europe and the gap between the European index and its US counterpart is historically closely correlated with the movements of the Markit iTraxx Senior Financials.

Banks have underperformed the broader market in recent weeks, a reversal of their strong showing in the second-half of last year. This reflects their status as high-beta credits. Political risk has flared up again in Italy and Spain, and this has had a knock-on effect on banks in the eurozone's periphery.

The particular set of problems surrounding beleaguered Italian bank Monte dei Paschi have made matters worse. The nationalisation of Dutch bank SNS Reaal has also triggered volatility, notably in subordinated debt.

Underperformance in banks, political risk and LBO speculation have all combined to widen the gap between European and US credit. A close Italian election later this month could trigger more volatility and exacerbate the trans-Atlantic division.

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