LONDON (Reuters) - The prospect of a more spendthrift government in Italy, already one of the euro zone’s most indebted economies, has had only a mild impact on Italian government bonds — leaving many market pundits puzzled.
Even after news in the past 24 hours that a coalition between the anti-establishment 5-Star Movement and far-right League could bring demands for 250 billion euros (218.4 billion pounds) of debt to be forgiven, the Italian/German bond-yield gap remains five basis points narrower than immediately after March 4’s election.
Money managers cite five main reasons for the relative resilience of Italy’s sovereign bonds despite often-negative commentary from overseas brokers and hedge funds.
First is the ongoing scale of European Central Bank purchases. Second is the relatively low foreign ownership of Italian sovereign paper. Third is the unusually long average maturity of Italian government bonds. Fourth is relatively high yields in a still largely zero-interest-rate world.
And five is an underlying assumption that any new 5-Star government will not seek a confrontation with the European Union on fiscal rules, and that rhetoric at hustings or even during coalition talks is likely to be toned down or tempered by Italy’s influential president.
“Are we concerned that financial markets may despair about going from one unconvincing coalition government in Italy to another one?” said Paul O’Connor, head of Janus Henderson’s multi-asset investing, whose funds manage 5 billion pounds.
“The short answer is no.”
Italy offers some of the highest yields of European government bonds in the investment-grade sphere, at nearly 2 percent in 10-year maturities. That compares with Portuguese PT10YT=RR and Spanish ES10YT=RR debt yielding 1.73 percent and 1.35 percent respectively.
Graphic: Italy offers juicy yield for bond investors - reut.rs/2IkkUZR
Italy’s relatively high yields at a time of generally low financial market volatility make Italian bonds more attractive on a risk-adjusted basis for many investors.
Graphic: Italian debt offers better yield for European investors - reut.rs/2IkOXAw
Wall St’s VIX index of implied equity volatility fell below its four-month moving average this week for the first time since January, according to UBS, while bond and currency equivalents remain close to the historic lows seen at the end of 2017.
European Central Bank asset-purchases have kept borrowing costs across the euro area low, but that bond buying has been especially strong in Italy.
The ECB has upped bond buying in countries such as Italy and France to compensate for shortages of eligible debt elsewhere, including benchmark bond issuer Germany. ECB holdings of Italian debt relative to the capital key — where the ECB buys government bonds in relation to an economy’s size — is among the largest in the bloc.
ECB data shows that cumulative government bond purchases in Italy, one of the bloc’s biggest bond markets, are among the highest in the region.
Graphic: ECB's public sector purchase programme - reut.rs/2rGOL4e
Apart from the ECB, domestic savers own 69 percent of outstanding Italian debt, an unusually large chunk compared to some of its peers such as Spain and Germany where local buyers account for 59 and 47 percent respectively, according to Nomura.
Such low foreign ownership helps insulate the Italian bond market from the ebb and flow of international risk appetite, speculation and currency shifts. Overseas investors, particularly outside Europe, hold only 5 percent of Italian debt compared to ownership in other peripheral bonds such as Spain’s and Portugal’s which is in double digits.
Data last week showed Japanese investors’ ownership of Spanish bonds hit a record high in March while purchases of Italian bonds fell.
Graphic: Overseas holdings of euro area debt (%) - reut.rs/2rHcUrc
4/ LONG-TERM PLAN
Like its peers, Italy has taken advantage of low borrowing costs to extend the average remaining maturity of its debt, which now stands at over seven years. In comparison, average residual maturity of outstanding German debt is around six years while U.S. Treasuries is around 5-1/2 years.
That means that in a rising bond-yield environment, it would take much longer for market moves to feed through into the total cost of funding Italian debt — providing an additional buffer.
5/ LOW BREAK-UP RISKS
For some, the ECB’s dominant position in euro sovereign debt markets and its stated objective of reducing fragmentation of borrowing costs across the zone beyond that acts as a backstop as long as overall euro breakup risks remain low.
This implied ‘breakup’ risk, which had soared at the height of the sovereign debt crisis in 2011/2012, has subsided since France elected centrist Emmanuel Macron as president last year and Germany re-elected centre-right Chancellor Angela Merkel.
The cost of insuring exposure to Italian sovereign debt has crept up again to late March levels but remains a fraction of what it was during the 2010-2012 crisis and in early 2017 when concerns about a euro zone breakup peaked again ahead of French presidential elections.
Graphic: Italian CDS - reut.rs/2rHedX8
“Everything coming out right now on balance is not good for the Italian credit, however as long as the fundamental architecture of the economy remains in place, the market will be okay with the risks,” said Peter Schaffrik, global macro strategist at RBC in London.
“If there is political will to take Italy out of the EU there is nothing that can be done about that.”
Reporting by Saikat Chatterjee and Dhara Ranasinghe; Graphics by Ritvik Carvalho; Editing by Mike Dolan and Catherine Evans