With the momentum clearly being negative on Spanish sovereign debt, and by extension Spanish corporate debt, Bank of America Merrill Lynch has noted that the sovereign's foray into junk status could have a hefty transformative effect on the European high-yield market. In essence, there may be too much of it for the market to absorb.
As it stands, the high grade index contains about €27 billion of debt from financials and €47 billion from non-financials - €16 billion of the latter represented by telecoms company Telefonica, which benefits from exposure to Latin America. The high-yield index has a face value of €172 billion - meaning that if things go nuclear the high-yield index would grow by a whopping 43%.
BAML has done a projection of how the high-yield index will look if we see mass downgrades of Spanish debt. Now as BAML freely admits, this is pretty rough stuff - they're using today’s prices to calculate index weights, whereas prices, and index weights would drop post-downgrade.
If you haven't noticed, the top five there? All Spanish. But let's not panic here, quite a few of these would need to see some serious slashing before they hit high-yield territory:
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As highlighted above, Spanish corporates and (senior) financials are slightly further away from being junked than is the case for the sovereign. In table 4, we show the current ratings of the largest Spanish non-financial issuers in highgrade, and the number of notches ratings would need to be cut before bonds enter BofAML high-yield indices.
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With the notable exception of Repsol - number nine on BAML's post-downgrade chart - these guys all have a decent cushion before they hit junk.
Even if BAML is looking at a worst-case scenario for Spain here, it's not outside the realms of possibility - and seeing the European high-yield index increase in size by almost 50% could have some interesting effects on the technicals in the high-yield market. And not in a good way.
In any case, lower economic output, declining sovereign and corporate creditworthiness and vanishing intra-regional capital flows should continue to boost the supply of high-yield bonds in the region. And that's not to mention the fact European banks' balance sheet constraints will force companies to issue more in the primary fixed income markets in the years ahead.