The Case for Italian Bonds in a Zero-Yielding Environment

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Recently, the US and the UK have joined Japan and Germany in the convergence of their 10-Year yields towards zero. This low rate environment has allowed the perpetual monetisation of sovereign debt to the point of almost no interest payments. And while the components of Modern Monetary Theory have allowed governments to run up significant deficits, the actions of Central Banks around the world have virtually eliminated any positive real returns from government bonds.

With the current economic and financial climate, the case for Italian bonds, both for investors and the Italian government itself, becomes intriguing. Caught between the economic powerhouses of Western Europe and several struggling, debt-induced economies of southern/eastern Europe, initial spikes in yields following the COVID-19 outbreak have since been placated. Following this, heightened investor appetite for Italian bonds has been centred around the ECB’s Pandemic Emergency Purchase Program (PEPP). With asset purchases to date of over €1.35 trillion, Italian bond yields have fallen with the ECB acting as a lender of last resort with the pandemic situation in Italy improving significantly. The 10-year Italian yield currently stands at 1.14%, down from 1.37% on June 25th. The Italian 10Y vs Bund 10Y spread, a general proxy for investor fear regarding the Italian economy, has fallen from highs of 270bp in mid-March to around 170bp.

Italian 10Y / Bund 10Y Spread. Source: highcharts.com

For smaller countries like Italy, now could be the perfect time to leverage up. The improvement in sentiment recently has led Italy, along with other countries such as Spain and France, to benefit from bull flattening. This is where longer term yields fall at a quicker rate than short term yields, which are stuck near negative levels. Declining yields leads to lower borrowing costs for the Italian government. With business investment expected to decline by 10.6% for the year 2020, low rates on long term sovereign bonds (2.2% on 30Y) could provide the conditions necessary to boost business cash flow and support production chains.

Sceptics of the Italian situation may rightly question the further adding to the country’s debt burden. Italy’s sovereign debt problems have consistently fell short of the ECB’s desire for monetary and economic convergence amongst all member states. Italy’s debt was 134.8% of GDP in 2019, with its dollar amount of debt the highest in Europe. Non-existent inflation and the lack of autonomy over monetary decisions means the real value of Italy’s debt will not dissipate any time soon. Unlike the G4 countries mentioned above, Italy could have a much harder time in continually monetising its debt, raising questions over the likelihood of sovereign default.

Italy’s Debt / GDP is second only to Greece in Europe

And yet, the general consensus of financial markets is that Italy’s debt situation is sustainable. Sovereign yields of countries with debt issues should naturally reflect the higher credit risk (Fitch’s last credit rating for Italian government bonds was BBB-). But with 10-year yields close to 1%, there seems to be little panic amongst investors. Italy could follow the activities of western Europe, adequately servicing their debt in the low rate environment whilst actively looking for ways to either reduce spending or generate higher tax receipts. If investor sentiment wavers at any point, then ECB action should be enough to keep borrowing costs low.

On the buy side, the slightly higher credit risk premia associated with Italian bonds could provide tempting rates of return. The risk-off sentiment from March-May has led to investors stockpiling cash, along with gold. As the global economy recovers, investors will be looking for somewhere to place that cash. With the QE activities of the Federal Reserve leading to radically overpriced U.S Treasuries, Italian sovereign bonds could offer attractive diversification benefits and higher yields than most of western Europe. Short term, positive carry trades or futures contracts could be utilised if recovery is stable and the monetary actions of the UK and US continues to push down yields.

However, these trades are not without risks. It is not only retail investors that have been interested in Italian bonds, with Italian banks also raising their net holdings of Government debt since 2018. If Italy’s public debt situation escalates at any point or general confidence wavers, bond prices will fall. In this scenario, large bank holdings of Italian debt severely affects the value of their assets, prompting a sell-off in order to meet boost cash flow. This could restrict lending to households which would prevent an adequate recovery of the economy. To prevent negative shocks like this deeply hurting the economy, Italy is largely dependent on the external support offered by the ECB’s to continue to suppress short-term refinancing costs and provide bank liquidity through its net asset purchases.


References

  1. John Ainger, “Italy’s Bonds Are Euro Area’s ‘High-Yielding Play’ of the Summer”, Bloomberg (July 2020), https://www.bloomberg.com/news/articles/2020-07-12/italy-s-bonds-are-euro-area-s-high-yielding-play-of-the-summer?srnd=markets-vp
  2. Marcus Ashworth, “Italy Has a Golden Opportunity in the Bond Market”, Bloomberg (2019), https://www.bloomberg.com/opinion/articles/2019-09-11/italy-has-a-golden-opportunity-in-the-bond-market
  3. Olivier Blanchard, “Italian Debt is Sustainable”, PIIE (March 2020), https://www.piie.com/blogs/realtime-economic-issues-watch/italian-debt-sustainable
  4. Kate Allen, “Italian bank bond binge revives fears of sovereign ‘doom loop’”, Financial Times (2019), https://www.ft.com/content/07ad20c8-3a83-11e9-b72b-2c7f526ca5d0
  5. Italy Credit Rating, Trading Economics (2020), https://tradingeconomics.com/italy/rating
  6. William Watts, “Pandemic bond-buying program is now ECB’s real crisis-fighting ‘bazooka,’ analysts say”, MarketWatch (2020), https://www.marketwatch.com/story/pandemic-bond-buying-program-is-now-ecbs-real-crisis-fighting-bazooka-analysts-say-2020-06-04?mod=mw_quote_news
  7. World Government Bonds, Italy’s Yield Curve & Spread vs Bund 10Y, http://www.worldgovernmentbonds.com/
  8. Stefano Manzocchi, “The Italian Economic Outlook 2020-2021”, Confindustria (2020), https://www.confindustria.it/wcm/connect/01f1ad4b-d609-4728-b975-9e2d4a184e01/Italian+economic+outlook+2020_2021_Summary+and+main+conclusions_310320_Confindustria.pdf?MOD=AJPERES&CACHEID=ROOTWORKSPACE-01f1ad4b-d609-4728-b975-9e2d4a184e01-n4NCcZg

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