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Europe’s corporate bonds send an ominous signal

Who are you going to believe about the prospects for a fix in Europe?

As German and French leaders head into yet another meeting seeking a magic bullet, the signals from share prices and corporate bond prices are very different.

Is your money on stocks, which are on the rise again, and a government bond market where the European Central Bank is papering over problems with a buying binge, or a corporate bond market that's in increasingly bad shape?

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The Stoxx Europe 600 index is up close to 4 per cent in the past week, coming off the big bottom, with traders talking about bargain hunting.

Government borrowing costs have stabilized and the cost of insuring European government debt has declined in that period after the ECB spent €22-billion ($31-billion) snapping up paper from countries such as Spain and Italy (and in doing so opening itself to criticism that it's Europe's biggest bad bank).

But in the corporate bond market in Europe, where there's no such buyer of last resort, there are not many buyers at all. The fear trade is still full on. In the past month, an index measuring the cost of insuring European high-yield bonds against default has jumped by 36 per cent, including a big jump last week.

Investors are afraid of a chain reaction that could begin if the sovereign debt crisis can't be reined in because European leaders like German Chancellor Angela Merkel and French President Nicolas Sarkozy can't agree on a bold enough plan. In that scenario, the euro would comes under even greater pressure and European banks would star to teeter because of the losses on the sovereign bonds they hold. Then credit would start to disappear in a localized version of the global panic that struck during the 2008 financial crisis.

Even now, solid companies' bonds are hurting, there's a "sell at all costs" mentality and nobody's on the other side to bid.

"It's bad," Suki Mann, a London-based Société Générale credit strategist, reported at the close of European markets on Monday. "Such as been the level of fear, we've seen investor behaviour and subsequent price action akin to the dark days of 2008."

Mr. Mann said "it smacks of panic and fear – unless, of course, the euro breaks up."

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Those are grim words, given that there's an argument that bond traders, who are closer to the centre of the debt mess, should have a better sense of which way the European situation will break. That's the way it was in 2007, when debt markets anticipated the recession of the credit crisis well before equities did.

It's hard in North America, even for business people who deal in the rough economy of the U.S., to relate to just how deep the upheaval is in Europe.

"Sometimes you see opportunities and risks through the spectrum where you sit," Bruce Flatt, chief executive officer of Brookfield Asset Management, said last week on the company's conference call. "We see it through Canada, Australia and Brazil, which are in outstanding shape, and the United States, which is recovering in our view. We don't see it through Europe and I think if you saw it through Europe, you might have a different view."

There is just not much hope in Europe's corporate credit markets that Germany's Angela Merkel and France's Nicolas Sarkozy will do much more than what they always do when they meet later Tuesday: talk.

The problems are just too intractable, especially when Germany, which has the money, has an electorate that is in no mood to hand it over to indebted nations. A Bloomberg-YouGov PLC poll released Monday showed 59 per cent of Germans didn't want bailouts used even to save the European Union, and 75 per cent of those polled didn't like how Ms. Merkel had been handling the situation.

There's not much expectation that the politically weakened German leader will push for anything radical today.

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On Monday, investors seemed to be preparing for disappointment.

Corporate bond markets stopped their selloff, but analysts chalked that up in part to the fact that some European markets weren't open for the day, as well as investors just being "simply on the sidelines facing exhaustion from last week's market gyrations and awaiting [Tuesday's] meeting," said Otis Casey, an analyst at credit-tracking firm MarkIt. He said he expects the meeting to be a non-event.

The German government backed him up. A spokesperson for Ms. Merkel has already warned that there will be no "big bang" solution forthcoming.

If that's the case, look for more selling in the corporate bond market, and more pressure on European companies.

"Markets have a tendency to rally into key European meetings before a subsequent reversal as no silver bullet is found," Jim Reid, a corporate bond strategist at Deutsche Bank, said in a dispatch to clients.

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