Just as the stock market took a beating today, to close below 10,000 the sovereign debt crisis in Europe continues to be the major theme to contend in other financial markets and is pushing risk aversion to high levels. According to financial information provider Markit, the Irish 5-year credit default swap widened to 340 basis points (bp) today compared to 266 bps on Thursday. Spanish 5-year CDS has widened to 320bp today from 258bp yesterday and Greek 5-year CDS paper also saw some movement wider to 790bp compared to 762bp on Thursday. Italian 5-year credit default swaps widened to 290bp yesterday. Financials have borne the brunt of the pain given banks exposure to sovereign debt. “One of the worst bouts occurred on Tuesday and Wednesday last week, when risky assets hit their lowest levels this year, but since then we have seen risk aversion recede,” according to Suki Mann at Société Générale. The concerns over the sovereign debt crisis in Europe engulfed US markets in May and according to figures reported by Barclays Capital, the MBS Index outperformed by 28bp and 2bp against swap and Treasury hedges, respectively. The relative outperformance against swaps was on the back of steady widening in swap spreads over the month, while convexity and vega losses were significant owing to high volatility in May. Higher coupons generally outperformed Treasury hedges for conventional and Ginnie Mae 30 year mortgages. In the Fannie Mae (FN) 30 year sector, 6.0 years underperformed because of Fannie Mae buyout activity in these coupons in March, which are being reflected in the index one month afterwards. Similarly, FN 5.5year and lower should see large paydown losses next month owing to the buyout, explained analysts. For non-agency residential paper the market has an apathetic feel to it as the bid list activity has died down. According to Jesse Litvak, a mortgage trader at Jeffries, “Offerings are sticky/firm and bids are the same that leads to a standoff where neither side is feeling compelled to do much.” Hybrid ARMs underperformed Treasuries and swaps in May by 32bp and 10bp, respectively. The worst performing hybrids were in the 0-12 WALA range, while higher WALA 5/1s and 7/1s outperformed. 10/1s underperformed across coupons and WALA, while higher coupons for other products performed better. “On the back of duration changes, we forecast that both the total and excess return risk of the MBS index will decrease by 19bp and 8bp per month, respectively,” said analysts at Barclays. But buyers may find some respite in some of the strong economic data that was reported this month. This week the market reported strong US car sales data, and the European PMI indices showed further progress. “This positive news is starting to encourage risk appetite again,” said Mann. “Equities are rising across the globe and the iTraxx indices tightening gently. Both markets remain fragile, but at least they continue to improve.” The author holds no relevant investments.