All year peripheral nations floundered and sturdier ones felt the forceful wave of contagion, writes SUZANNE LYNCH

IT WILL be remembered by many as the year the “markets” became the real protagonist in the European sovereign debt crisis, driving sweeping policy changes and political intervention, and leading to the ousting of three prime ministers.

While concerns about the ability of some countries to finance their debt and manage their budget deficits had resulted in a significant widening of government bond yields in 2009 and 2010, concern was largely confined to the so-called peripheral nations, with Greece, and then Ireland, forced to request an EU-International Monetary Fund bailout in 2010 after the cost of borrowing became unsustainable.

In 2011, the crisis spread to the core, and countries once deemed too big to fail saw their cost of borrowing reach unsustainable levels.

The year itself started relatively positively. Following the EU-IMF deal for Greece and Ireland in late 2010, market sentiment was characterised by optimism that Europe was beginning to tackle its sovereign debt crisis following bailouts for Greece and Ireland, with Spain and Portugal seeing strong investor interest in the first debt auctions of the year.

By early spring, however, the borrowing costs of the Iberian countries began to rise, with attention increasingly turning to Portugal. Following a downgrade in March, and the collapse of the Portuguese government, Portugal called for a bailout in early April. By early May, the country became the third euro zone nation to seek an EU-IMF rescue package, with the heavily indebted country receiving a bailout of €78 billion.

In June, the crisis resurfaced, as the refinancing of Greek public debts became the next focus of investor interest. A second rescue deal beckoned and, in late July, euro zone leaders agreed a second deal for Greece – one that included private bondholders taking a writedown – in an effort to stop the euro zone crisis spreading to Italy. While the deal succeeded in calming the markets temporarily, bond markets were rattled when the US was stripped of its prized AAA rating by Standard & Poor’s in early August, following protracted political discussions about raising the US debt seiling.

The second half of the year saw the situation deteriorate further, with Spain, Italy and even core countries such as France and Germany seeing their borrowing costs rise. Italy entered the eye of the storm in October, with 10-year bond yields hitting 7 per cent and higher, territory widely perceived as unsustainable for the region’s third-largest economy. Mounting pressure led to Silvio Berlusconi’s resignation as prime minister in November, in the same week as Greek prime minister George Papandreou was forced to resign as he struggled to take command of the country’s response to the crisis.

The end of 2011 was no better for sovereign debt markets. By late November, the weakest German bond auction since the launch of the euro pushed the UK’s borrowing costs below Germany’s for the first time, raising concern that Europe’s largest and steadiest economy could be drawn into the euro zone crisis. After much speculation – and a downgrade error in early November by Standard & Poor's – in mid-December ratings agency Fitch revised its outlook on France to “negative” from “stable” though it affirmed France’s AAA credit rating. December also saw Standard & Poor’s placing 15 EU nations on credit watch negative, including six with AAA ratings.

The year also culminated in one of the most significant European summits since the creation of the single currency. Signed by 26 out of 27 EU states, the deal promised greater fiscal consolidation between the region’s economies, heralding a new era in European relations but leaving Britain potentially isolated, as British prime minister David Cameron refused to sign up to the agreement.

According to Donal O’Mahony of Davy Stockbrokers, the most significant issue for bond markets in 2011 was the question of private sector involvement. “The threat of haircuts hung over the markets throughout the year,” he says, pointing out that a turning point was the acknowledgment in April by German finance minister Wolfgang Schäuble that debt restructuring – an option that had been routinely dismissed by EU authorities – might be considered. This, in turn, led to the Greek deal in July which imposed losses on bondholders.

“The decision to impose a haircut on the holders of Greek debt in the July deal was effectively a default. It led to investor withdrawal, which affected countries like Ireland and Portugal, and spread to Italy and Spain,” he says.

“If you look at Irish bond yields for example, they jumped from about 8 per cent to 24 per cent between mid-April and mid-July.”

Noting that private sector involvement was ultimately removed from December’s EU summit deal, he argues that private sector involvement was the reason why Moody’s downgraded Ireland’s debt rating to junk status in July.

Similarly, Grant Lewis, of Daiwa Capital Markets in London, describes 2011 as a “crisis of confidence” rather than a response to individual levels of indebtedness of each country.

“The differences between Italy and Spain in terms of their debt profile are so stark, and yet both were the subject of the same kind of investor withdrawal. This shows it’s an issue of confidence.”

Another contentious issue during the year was the European Central Bank’s intervention in bond markets. The ECB (which saw Mario Draghi replace Jean-Claude Trichet as president) began its bond-buying programme in May 2010. Despite repeated assertions that bond-buying was not a long-term solution to the crisis, its level of purchases was nonetheless significant in 2011, as it sought to alleviate soaring borrowing costs for Italy and Spain. According to Barclays Capital, the ECB bought an average of €10 billion a week in the third quarter of 2011, and €5 billion a week in the fourth quarter.

While the “contagion” effect of the euro zone crisis was one of the recurring concerns of 2011, as the sovereign debt crisis spilled over from the peripheral nations to some of Europe’s largest economies, contagion was also at play in terms of the knock-on effect on private institutions such as banks.

In 2011, the interconnectedness of the European and global banking system and sovereign debt was exposed, as banks, along with insurance companies and pension funds, were revealed as the major holders of euro zone sovereign debt. This left some of the world’s biggest banks facing major write-downs, particularly through their holdings of Greek debt.

One of the knock-on effects was ratings downgrades. In December, Fitch cut the ratings of seven banking giants (including Bank of America, Goldman Sachs, BNP Paribas, Barclays, Deutsche Bank and Credit Suisse), while some of the world’s largest insurance companies were also put on negative watch by Standard and Poor’s. It also meant that banks reversed their long-term policy of buying sovereign debt, with the result that countries were in effect abandoned by their most regular customers. This was accompanied by the widespread offloading of sovereign debt by banks. Both moves raised pressure on the ECB to keep buying Italian and Spanish debt to keep yields down.

In terms of the effect of the sovereign debt crisis on individual investors, 2011 predictably saw some investors withdraw from bonds – once the safe bet of the investment portfolio – particularly of the peripheral countries. “In 2011, it wasn’t about maximising your gains; it was a case of capital preservation,” says Alan McQuaid of Bloxham Stockbrokers.

During the year, Bloxham and other brokerages saw a demand for fixed-income products that offered exposure to treasuries, gilts and the debt of other nations perceived to be aligned to Germany, such as Finland and the Netherlands, as investors put security over high return.

Despite being out of the debt markets until 2013, 2012 will be a crunch year for Ireland.

With a mountain of euro zone debt to be refinanced in 2012 – according to Citigroup, euro zone governments need to refinance €1.1 trillion in 2012 – Ireland will be hoping that next year will yield a firm resolution to the euro zone crisis ahead of its return to the markets in 2013.