The European Central Bank skyscraper headquarters building in Frankfurt, Germany
Most of the damage has stemmed from expectations that the European Central Bank will follow the US Federal Reserve in raising interest rates as it grapples with surging inflation © Alex Kraus/Bloomberg

European corporate debt has been hit by its heaviest pullback on record as fears over persistently high inflation and the threat of a recession send traders dashing out of the market.

Bonds issued by highly rated companies in the eurozone have lost investors more than 10 per cent since the peak nine months ago, marking by far the biggest decline since at least 2000 for an asset class typically expected to deliver much steadier returns than stock markets, according to an Ice Data Services index.

Most of the damage has stemmed from expectations that the European Central Bank will follow the US Federal Reserve in raising interest rates as it grapples with surging inflation. On Wednesday, ECB chief Christine Lagarde signalled she would support raising rates in July.

Line chart of Euro corporate index (total returns) showing European high-grade corporate bonds in historic pullback

That prospect has hit bonds of all stripes. But the so-called spread offered by corporate bonds — the extra yield they offer relative to government debt — has also begun to widen, indicating that investors are worried about a looming economic slowdown that could weigh on companies’ ability to service their debt.

The sell-off has been driven by “inflation being stickier than expected”, which has fuelled expectations of central bank tightening, said Vivek Bommi, head of European fixed income at AllianceBernstein. “In September, the word used with inflation was ‘transitory’ and I don’t believe anyone uses that word any more.”

The pressure on corporate bonds mirrors strains in other fixed-income asset categories, almost all of which are seeing “fairly significant outflows”, Bommi added.

High-yield bonds issued by companies with lower “junk” credit ratings have also been hit, although the sell-off so far has proved less intense than the rush away from risky assets seen during the early stages of the coronavirus pandemic. European junk bonds have, collectively, fallen 10 per cent on a total return basis so far in 2022, according to an Ice index.

The spreads on these European high-yield bonds, which indicate investors’ perceptions of default risks, have also risen to 5.15 percentage points from 3.31 percentage points since the start of the year, the widest level since July 2020.

Line chart of Euro corporate index (spread, percentage points) showing Recession worries seep into European credit market

Still, some investors question whether this relative resilience is likely to last given the threat to economic activity posed by soaring energy prices.

“There’s been a synchronised sell-off that’s been interest and inflation driven, with high quality underperforming more than lower quality market,” said Mike Scott, a portfolio manager at Man Group focused on credit. “We expect this to reverse as we go into the second part of the year,” as the economic outlook for Europe darkens, he added.

Widening spreads “indicate that there is higher risk in corporate credit but also shows that as financial conditions become tighter, with the ECB saying it will no longer purchase European corporate bonds, lack of demand leads to repricing of bonds”, said Daniel Lamy, head of European credit at JPMorgan.

“The growth outlook has come more into question in the past month or so because of the war in Ukraine, the China lockdowns and inflation eating into consumer demand,” said Lamy.

Additional reporting by Tommy Stubbington in London

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