Investors have been flocking to Italy’s bond sales since the start of this year — a welcome reprieve following repeated bouts of selling in 2018. But the attraction lies in the country’s high and still volatile bond yields — and that is not exactly a vote of confidence from markets.
On the surface, the outlook for sovereign debt sold in the world’s ninth largest economy is improving. Fears of a political crisis in Rome have ebbed since a budget wrangle with Brussels was resolved late last year, while the end of the European Central Bank’s quantitative easing programme of bond buying in December has not shaken the debt markets as some had expected.
Last week Italy saw €41bn of orders for €8bn of 30-year bonds, a record oversubscription.
“Fears about how the market would digest European government bond issuance in January were misplaced and the same applied to Italy,” said Gianluca Salford, a fixed-income strategist at JPMorgan.
But beneath this lies a more negative picture, say analysts. Italy’s popularity rests on the higher yields its debt market offers after last year’s heavy sell-offs.
Italy’s 10-year bond last week briefly touched 3 per cent for the first time in two months, reflecting a fall in prices. That gave investors a 2.9 percentage point premium over the equivalent German government bond.
These kinds of Italian yields are especially appealing in part because the eurozone’s waning economic outlook means that policymakers have pushed back the timeframe for rises in interest rates. Expectations for the ECB’s first rate rise have shifted from the middle of this year into mid-2020.
That means eurozone sovereign debt bearing a high spread over German bonds have come to look attractive again. In other words, Italy’s bond market is like Goldilocks’ porridge: not too hot, or risky, and not too cold, or safe, but just about right.
“Central bank dovishness is a signal for investors to add risk and yield,” said Adam Kurpiel, head of rates strategy at Société Générale. “For now, [investors] can enjoy the sweet spot [and] keep exposure to higher yielding assets like [Italian government bonds].”
He predicted that 10-year Italian debt yields would shrink, taking the gap between them and German yields to 2.2 percentage points, but warned that investors should keep an eye on how new bonds were received by the market “for any signs of investor indigestion”.
Meanwhile, Italy’s borrowing comes at a heavy cost. A year ago, 30-year Italian bonds yielded 2 per cent; in last week’s record-breaking sale, the coupon was set at 3.85 per cent.
That means Italy will pay an extra €148m of interest on that bond each year, over and above what the country would have paid had prices remained at levels last seen early in 2018.
Overall, the Bank of Italy estimated in late November that the country would pay an additional €9bn a year in interest costs on its debt by 2020, if yields remained around current levels.
Sergio Bertoncini, head of rates and currencies research at European asset manager Amundi, estimated that at current yields, Italy’s average funding costs would increase from 1.07 per cent last year to between 1.3 and 1.4 per cent this year.
“Despite the slight rise in funding costs, the average cost of overall debt remains low versus previous years and should not be strongly impacted in the next one to two years,” Mr Bertoncini said. “However, the year has just started and it remains quite challenging in terms of overall funding needs and supply.”
In all, Italy needs to sell at least €225bn of medium- and long-dated debt this year. So far, its fresh fundraising has not been offset by redemptions of existing bonds — a factor that tends to boost demand, as investors seek to replace bonds that have just matured.
In February and March, €72bn of debt is set to mature, which could help to steady yields in the coming weeks.
In the longer term, however, Italy looks vulnerable. Late last year it slipped into a technical recession for the third time in a decade, and it faces a worsening demographic situation.
“Despite the fact that weaker-than-expected growth is a common factor in the [eurozone] at the moment, markets are still assigning much more significance to weaker growth in Italy than in the other countries,” said Chiara Cremonesi, a fixed-income strategist at UniCredit. “This is clearly related to the impact of weaker growth on Italy’s much higher debt/GDP ratio.”
Italy’s budget deal with Brussels, which keeps its deficit this year to below 3 per cent of gross domestic product, rests largely on optimistic growth assumptions. Prolonged weakness, therefore, could reignite the political row — and push Italy closer to the edge of its investment-grade credit rating.
“Lower than expected GDP growth automatically increases the deficit and the risk of negative action from rating agencies,” JPMorgan’s Mr Salford warned.
That means the current truce between markets and politicians may not last long.
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