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The dramatic sell-off in European credit markets continued Wednesday morning following Tuesday’s leaps in the cost of protecting corporate debt against default - sparked, in turn, by news of potential ratings downgrades to US sub-prime mortgage backed bonds.

The iTraxx Crossover index, which acts as a barometer for risk appetite in European corporate debt, burst through 300bp at one point late morning, up about 53bp, which means it costs more than €300,000 annually to protect €10m worth of junk rated debt against default over five years.

This cost is about 50 per cent higher than it was a month ago, illustrating the extent of the recent volatility. In the US on Tuesday night, the equivalent CDX Crossover index closed at about 228.5bp, according to Markit Group, after rising about 72bp on the day. The cost of protection there is about 46 per cent higher than a month ago.

The mild panic has been sparked by news that Standard & Poor’s had put about $12bn worth of bonds backed by sub-prime mortgages in the US on watch for possible downgrade. Rival ratings agency Moody’s then disclosed after markets had shut that it had downgraded about $5bn worth of similar bonds.

The reasons this is important to corporate credit markets in the US and Europe are twofold.

Firstly, there is the long-held concern that problems in one segment of the US mortgage market could spread to other areas and spark a spiral of falling house prices and slowdowns in consumer spending. The knock on effects of this to the US economy broadly and then the global economy could harm the corporate credit boom of the past few years.

The second concern is related to the transmission mechanisms in modern credit markets, whereby problems can leap between seemingly unrelated markets such as US mortgages and European leveraged loans, which are funding the current buy-out boom.

These transmission mechanisms work through both creating problems in the complex structured products that invest in diverse credit markets and through the impact of hedge funds withdrawing cash from different markets as they are forced by their bank lenders to meet margin calls or re-value their holdings.

If contagion between markets is fueled by such mechanisms then the sell-off in credit could be the harbinger for a much broader systemic sell-off of risk across all asset classes - that at least is the most bearish, apocaliptic version of current market concerns.

On Monday, Bear Stearns Asset Management is expected to have completed the re-valuation of all the mortgage-related complex bonds its two crisis-hit hedge funds were holding. Public release of these valuations, or even strong rumours, are likely to lead other investment banks to reassess their risk positions in terms of lending to funds with similar exposures.

Any withdrawal of liquidity from other funds could increase the spiral of sales and falling values in complex credit products of many different kinds, depending on who is holding what. So, anyone who was hoping for a quiet summer break in the credit markets could well be sorely disappointed.

Catch Paul J Davies’ video on the subject here.