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Fixed income outlook: another Italian drama on the way this summer?

03 May 2019

By Michel Vernier, Head of Fixed Income Strategy

Spreads of Italian government bonds have retreated significantly since the highs of October 2018. We think upcoming renewed budget discussions and political uncertainty may lead to higher volatility again. Apart from the sovereigns, Italian bank bonds would be most affected by a resurgence in volatility.

Italian government bonds

Government bond auctions usually provide a good insight into investor sentiment towards the respective sovereign bond market.

On the 11 April Italy auctioned €2.5bn of 2022 bonds among others and investors offered to buy 1.62 times more the amount of that bond than sold (bid to cover ratio) at a yield of 1.08%.

The healthy demand was one of the reasons why the Italian 10-year bond yield marked an almost 12-month low at 2.37%.

Yields have fallen a long way since the 3.7% highs seen in October 2018 when Italy clashed with the EU on the back of budget discussions.

Furthermore, since then Italian bonds have been supported by Moody’s decision to maintain Italy’s BBB- rating with a stable outlook. However, sentiment can change quickly as seen in the past and we may witness this again in coming weeks or months.

italian government bond yields

Political uncertainty

Back in February, Italy avoided paying a penalty through the excessive deficit procedure, which is regulated by the EU. However, the presented budget lacks a solid foundation and given the political uncertainty faces implementation risks in Italy.

The initial budget targeted a deficit of 2% of gross domestic product (GDP) in 2019 and 1.8% and 1.5% in the years 2020/2021, based on lowering spending costs, pension reforms as well as value-added tax (VAT) hikes in 2020/2021.

The VAT hike is a very sensitive topic and has most recently been challenged publicly by the Five Star Movement leader and Italy Deputy Prime Minister Luigi Di Maio.

Without an increase in the VAT rate, the budget seems unsustainable and is likely to surge to 3.4% of GDP and breach EU budget rules according to the Bank of Italy. Italy has since revised the budget deficit to 2.4% of GDP for 2019, which still seems out of reach.

Optimistic assumptions

The path to debt reduction is based on a very optimistic growth assumption in our view. Although Italian growth has recovered from the technical recession it experienced in Q4 2018 and Q1 2019, the government’s growth assumption is very likely to be revised down from 1% of GDP closer to 0.6% of GDP as projected by the International Monetary Fund. Growth may even head towards the 0.2% of GDP projection of the EU for 2019.

The low volatility in spreads seems to reflect investor’s expectation that an agreement will be reached within the Italian parliament as well as between the EU and Italy, which we argue, seems overly optimistic.

Investors may also rely on a change in the government given the recent momentum of the League party which is perceived as more constructive and investor friendly than the current coalition.

Although the odds of an administration change look increasingly likely due to ongoing frictions between the two ruling parties and a wide range of coalition scenarios, trading on the back of the expectation of an investor-friendly government seems premature in our view.

…we rather expect investors to demand higher premiums soon for a country which runs record debt levels of 132% of GDP (2018).

Given that the debate about the budget will likely heat up again in the next two to three months, the overly optimistic growth assumption and the prevailing and increasing political uncertainty, we rather expect investors to demand higher premiums soon for a country which runs record debt levels of 132% of GDP (2018).

Italian banks

Italian bank bonds will likely feel the impact of a potential resurgence of volatility in Italian sovereign bonds. Profitability of Italian banks is disproportionally affected by sovereign spreads.

Firstly, Italian banks have the highest domestic sovereign exposure in Europe with €396bn making up 10.7% of the banks’ assets while Spain’s banks, for example, holds an average of 7.6%.

Under updated international financial reporting standards (specifically IFRS9), a large part of these holdings need to be booked at fair value which directly eats into the profitability and capital of the banks should spreads widen.

Secondly, higher funding costs restrict growth, which Italian banks require in order to reduce loss charges on their existing loan book.

The good news is that the large Italian banks were able to reduce the proportion of the non-performing loans significantly due to disposals and securitisation. Loan loss charges have declined by 12% in 2018.

However, recent securitisation deals indicate that the mark-to-market value of impaired loans sitting on banks’ balance sheets may still be too high. The European Central Bank (ECB) has so far not provided final details about the renewal of the Target Long Term Repurchase Operation (TLTRO III) bank funding operation and Italian banks, as the biggest beneficiaries, will hope that the ECB will be generous.

Investors may prefer to be selective and focus on higher quality within the Italian banking sector.

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