First-quarter review

If one wanted to make a bet at the end of 2012 that a eurozone country would impose capital controls before the end of the first-quarter 2013, the odds quoted would have been long.

But the gambler in question would be counting his winnings today after Cyprus introduced limits on fund flows. The queues and riots outside banks didn't materialise - a disappointment no doubt to the waiting journalists. Nonetheless, there is little doubt that the Cypriot people will be venting their anger frequently during the years of austerity they now face.

Many investors beyond Cyprus have felt the impact of the debacle in the eastern Mediterranean. The first-quarter has been a relatively volatile one, mainly as a result of a revival in eurozone sovereign risk. As well as the mishandling of the Cyprus bailout, the ongoing political turmoil in Italy has stifled risk appetite.

Financials, and banks in particular, have suffered more than any other sector in Q1. The Markit iTraxx Senior Financials index looks set to close the quarter at 194bps, more than 50bps wider than where it started the year. The March roll added to the widening, but the events in Cyprus meant that the trend was unstoppable. To put it in context, the 200bps close on March 27 was the widest since October 1 2012.

Other sectors, of course, have been affected by the risk aversion sweeping through the market. However, the credit deterioration has been modest in comparison to the banks. The Markit iTraxx non-Financials, a non-tradable index, is now at 108bps, just 2bps wider than 2012 year-end levels. It seems that banks are being singled out as a weak point in the global economy by the credit markets, and not for the first time.

The bond market might be expected to show similar results; after all, it is just another form of credit risk. But the outcome of the first-quarter has been quite different. Sure, the asset swap margin of the Markit iBoxx € Banks Subordinated index does show some widening. The nationalisation of SNS Bank in the Netherlands and the bailing-in of subordinated bondholders spooked investors and led to spreads spiking in both cash and CDS. However, the equivalent index for senior debt barely moved, and trades inside the corporates index.

In short, spreads in senior bank debt have held on to their gains from the Draghi "whatever it takes" rally, unlike CDS, where spreads have gone into reverse. This will only increase the already high positive basis between bank CDS and cash. This will be explored further in the monthly basis report next week.

The underperformance in bank CDS makes perfect sense in light of recent events. Jeroen Dijsselbloem, the beleaguered Eurogroup head, let it slip when he said that the Cypriot bailout was the start of a process that would push the risks back from sovereigns. Uninsured depositors were the most high profile casualties of this new approach, but banks may feel the pain more acutely in the months and years ahead.

Senior bondholders are now going to share the burden of future bailouts, if and when they occur. This is right and proper - the alternative is the taxpayer footing the bill, as Ireland found out. Dijsselbloem's comments were ill-timed rather than incorrect - fragile banks based in the periphery could have done without him reminding the markets. Wealthier depositors will now think twice about keeping their funds in southern Europe, and this risk will now be priced into bank funding.

As we go into the second-quarter, the fallout from Cyprus - Slovenia is now the focus of attention - and the interminable political shambles in Italy will continue to influence sentiment. But we shouldn't forget about the US, which is facing rather different problems. Credit investors are trying to figure out if there is a bubble in bonds, whether rates will rise and if there will be a great rotation into equities. Idiosyncratic risk also has to be factored in, with private equity companies looking for the next LBO targets. It would be no surprise to see Europe and the US diverge even further in Q2.

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