While global markets are once again reeling from the next chapter of disastrous bank related earnings and the prospects of full government nationalization in several countries, another blow to investor confidence might be around the corner: a sovereign government default.

According to the Financial Times, global bond issuance in 2009 will reach an all-time high of more than $3 trillion dollars – three times greater than last year. In the United States, Treasury will auction almost $2 trillion dollars to fund monster fiscal spending packages and bailouts; in Europe issuance is expected to reach more than $1 trillion dollars.

Euro-zone Failed Auctions

Several European countries in the euro-zone have struggled to meet bond auctions, including the world’s second largest fixed income market – Germany.

Since October, Germany has failed to meet its bond auction targets on four separate occasions, either reducing or scrapping government bond auctions altogether amid poor investor demand.

Investors are growing nervous because of the unprecedented funding requirements for European fiscal spending in 2009 as the financial system yearns for a wave of fresh capital amid bank equity deflation. The United Kingdom has announced the first initiative to collateralize all toxic bank assets with implicit state guarantees – a first at this stage of the credit crisis.

Elsewhere in Europe countries like Austria, Spain, Belgium, Italy, Holland and Ireland are struggling as interest rate spreads versus German bonds continue to soar. Rising spreads mean investors are growing more risk averse and demand higher interest rate compensation compared to Germany – the regional safe haven market.

The euro zone is now awash in bond supply as countries race to sell debt to finance fiscal spending packages and increasingly, bank bailouts that will probably result in government nationalization of the battered financial services sector.

HSBC Credit Swaps Cheaper than Most European Governments

The cost of credit protection measured vis-à-vis credit default swaps (CDS), which protect lenders from an issuer defaulting, have soared over the last several weeks for the United Kingdom, Italy, Spain, Greece and Ireland among others.

It now costs more to protect against a default in several European nations than it does to insure against HSBC – the world’s biggest bank. That’s a major 360 degree shift in investor sentiment because 12 months ago the tables were turned in favour of sovereign governments.

Earlier in January, the rating agencies downgraded Greek and Spanish debt and other countries, including Italy, Belgium Ireland and the United Kingdom might be next.

A credit downgrade implies rising funding costs for government borrowers as the market places a higher interest rate premium on sovereign debt.

While funding gaps lurk for countries sporting bloated debt-to-GDP ratios, others in the emerging markets are in worse fiscal shape with the IMF already bailing out three countries over the last six months.

Debt-to-GDP Ratios Surge in Eastern Europe

While the financial panic gripping the industrialized nations has been frightening, particularly for Western governments, the scope of the disaster is now beginning to threaten the ability of some countries to service their debt burdens in the emerging markets. That’s because many countries in East and Central Europe have amassed a mountain of short-term debt obligations, threatening debt servicing as local currencies plunge.

In many ways, the current funding crisis among weaker emerging European borrowers is similar to what occurred during the Asian economic crisis starting in 1997. Most nations in the region also accumulated massive short-term debts denominated in dollars.

Many currencies in the emerging markets universe have crashed since last July, raising their cumulative debt servicing costs and limiting their ability to raise fresh capital from global investors. This is especially the case in the Baltics and the Balkans.

In 2008, Ecuador and the Seychelles defaulted on their debt.

Since last fall the IMF or International Monetary Fund has bailed-out Iceland, Hungary and Ukraine. More countries might be next in the emerging markets and quite possibly, even in the euro zone.

According to Deutsche Bank, combined current account deficits and debt of Eastern and Central European countries is around 18% of GDP or gross domestic product compared with only 8% in Asia and Latin America. Some countries are now in the danger zone with explosively high debt ratios, including Estonia, Latvia and Lithuania.

Credit Spreads Point to Danger, Possibly Default

In the euro zone, Ireland, Greece, Portugal and Spain maintain the highest credit spreads over German bonds in late January ranging from 3.39% for Greece to 1.73% for Spain.

Indeed, investors have demanded higher interest rates to compensate them for rapidly rising deficits in these and other euro zone countries.

Yet the credit spreads in Europe are kids’ stuff compared to recent developments in the emerging markets.

Ukraine, which has already received IMF aid, must rollover approximately $30 billion dollars of funding this year while Hungary requires $15 billion dollars. The spreads on Ukrainian dollar-denominated debt compared to benchmark U.S. Treasury bonds is now 26% -- only second to Ecuador’s 31%, which has technically defaulted in 2008. Other countries with soaring borrowing premiums include Argentina and Venezuela.

The odds are growing that one or more sovereign borrowers in East and Central Europe will default in 2009 unless the financial haemorrhaging stops. Local banks in these markets have been battered, currencies have declined sharply, liquidity is running dry and stock markets have collapsed.

Avoid Emerging Market Debt

Not all emerging market sovereign borrowers are threatened by default. Some countries, like Brazil, probably hold better risk adjusted returns than most industrialized countries over the next 12 months. Brazilian credit spreads have risen as well since last year but remain at a respectable 3.31% above Treasury bonds are still rated investment grade.

Yet for most emerging market bond issuers, the cost of raising capital is certainly on an uptrend in an environment of shrinking trade surpluses, rising deficits and a full-fledged recession in key export markets.

Investors should avoid emerging market debt as risk of default spreads and raises funding costs for even some of the safest credits. Spill over is already breaching the haul of several leading issuers.

The J.P. Morgan Emerging Markets Bond Index now yields 9.42% or 682 basis points (6.82%) more than Treasury bonds. That yield spread peaked last October at 12.21% at the height of the panic. Yet it would seem plausible that spreads will rise again as one or more sovereign borrowers in this asset class default. Many of the highest indebted borrowers, including Ukraine, have amassed huge amounts of short-term debt that must be refinanced.

The best time to buy emerging markets is amid a full-blown panic. Though we’re not at the point of maximum pessimism yet, investors will eventually feast on double-digit yield spreads as defaults increase in 2009.

Combined with crashing or weak currencies, this is not the time to be a hero in emerging market debt as default risk heightens.