Italian government bonds face a downgrade to “junk status”. Nevertheless, after years, the interest of foreign investors in this “ticking time bomb” is increasing.
The prolonged exodus of foreign investors from Italian government bonds has halted this year. According to research by Amundi Investment Institute, the asset class saw positive inflows of 35 billion euros in the first seven months, driven by foreign interest.
Investors also lengthened the average maturity, with net sales of short-term bonds at 17 billion euros, and longer-term securities purchases at 52 billion euros. Italian banks have slightly reduced their government bond exposure this year, while household investments have increased significantly, the researchers noted in a publication.
Earlier this year, Domenico Siniscalco, vice chairman of Morgan Stanley Europe and former Italian economy minister, described the renewed interest as a “magic moment,” in conversation with the Reuters news agency. He stated, “Italy is no longer seen as a target of speculation.” According to him, international investors now view the country with “total calm and confidence.”
However, investors currently demand 4.5 percent interest on Italian 10-year government bonds, 60 basis points above Greece, the only Eurozone nation with a higher debt ratio.
Bund spread
“Italy is a ‘ticking time bomb’,” asserts Stefan Zeisberger, professor of financial economics at Radboud University. “We just don’t know when it will explode.” He points out that the country still benefits from most of its debt being at low interest rates, but warns that the longer high rates persist, the more challenging the situation will become.
Italy is grappling with high debt (140 percent of GDP), a substantial budget deficit (5.3 percent), high interest rates (an average of 4 percent), and low real economic growth (0.7 percent in 2023). The economy grew by ten and three percent in 2021 and 2022, respectively.
Investors’ perceptions of these figures as problematic are reflected in the interest rate spread against German 10-year government bonds. This spread typically oscillates between 300 and 100 basis points. Currently, the extra demand is 180 basis points for Italy’s long-term government debt, not yet indicating panic.
Credit concerns
“The average maturity of Italian debt being seven years means the debt level isn’t an immediate concern, but low economic growth is,” says Francesco Giavazzi, former adviser to Mario Draghi and professor of economics at Milan’s Bocconi University.
“We must pay close attention to what credit rating agencies will say about Italy at the end of this month,” Giavazzi tells Investment Officer. “Remember, Italy has never defaulted in the past one hundred years, unlike Greece.”
Fitch and Moody’s this month issue their verdict on Italy’s status. The potential announcement by Moody’s Investors Service on 17 November is particularly critical. Moody’s currently rates Italian debt at Baa3, just a notch above junk, with a negative outlook. Last Friday, Fitch maintained Italy’s BBB rating with a “stable” outlook, one step above the speculative BB rating.
Tactical strategies
“For pension funds using government bonds to hedge interest rate risks, prioritizing security and stability is key,” says Rob Dekker, senior portfolio manager at Achmea IM. “Thus, strategically allocating to Italian government bonds is less advisable due to volatility risks and their unsuitability as collateral.”
However, Dekker notes that a tactical allocation to Italy could be beneficial. “A small allocation to government securities with a three to six-month maturity can yield additional returns,” he suggests.
EU stability
“The risk of a renewed debt crisis seems limited for now,” Dekker observes. “The European Union has demonstrated strong unity in recent years, and we expect this to continue.”
He highlights the ECB’s capacity to support local bond markets with the TPI program and control spread widening if necessary.
“Deploying a tool like TPI requires market pressure first. We anticipate the market testing the boundaries, determining at what spread level the ECB might intervene,” Dekker explains.
“This creates opportunities for us to deliver added value to our clients through tactical underweighting or overweighting in a country to achieve outperformance. However, this strategy applies to only a limited portion of the portfolio,” he adds.
Meanwhile, the European Union is revising the Excessive Deficit Procedure (EDP), the mechanism activated when a member state violates the Stability and Growth Pact’s fiscal rules. The fiscal rules themselves are also under review, following their suspension during the pandemic.