Investors might want to think again when it comes to Italian bonds as coronavirus turns conventional thinking of Italian debt on its head says Hendrik Tuch, Head of Fixed Income NL at Aegon Asset Management
Tuch cites two reasons for this recent reversal in conventional thinking around Italian bonds, calling the coronavirus crisis a “blessing in disguise” for the country’s finances.
“First, the recent appointment of Italy’s new prime minister, Mario Draghi, and his government bring stability to a historically volatile country,” says Tuch.
“As an economist with an impressive resume, Draghi has already gained the confidence of investors. For example, ‘The Draghi effect’ is helping demand for Italian bonds—even allowing the country to cut yields while still selling the full amount of debt it wanted in the most recent new debt offerings after Draghi took office.”
The second reason Tuch explains, is down to the EU’s coronavirus financial rescue programs that have given Italian bonds an added appeal which has yet to wear off.
“When the ECB introduced the Pandemic Emergency Purchase Programme (PEPP) this time last year in response to the global pandemic, it was an unprecedented stimulus with no limits on policy. Initially, the bond-buying program heavily weighted its purchases toward Italy.
“Since August, that has tapered off with signs of the crisis phase coming to an end with the introduction of several successful vaccines. But thus far, Italian government bonds have been able to sustain their appeal.”
Tuch cautions however that this “sweet spot” won’t last long-term as coronavirus support recedes and politics comes back into the frame.
“It is nothing new to point out that the low Italian sovereign bond yields and spreads are not made in Rome but in Brussels and Frankfurt, which is the main issue for the longer-term outlook on Italian sovereign bonds.
“Before Covid-19, the ECB was reluctant to add to its sovereign bond purchases; however, the pandemic turned everything on its head. On top of the ECB buying program, the Italian government can expect payments from the EU Recovery Fund for up to 12% of its GDP from Brussels in the next few years. The country is also able to refinance debt at much lower yields because of the ECB, so the coronavirus crisis has been somewhat of a blessing in disguise for Italy.
“In two years’ time or less, however, we believe the situation will become more uncertain as we face new elections and, by that time, the ECB will have pulled back some or all of its buying. Longer term we are therefore a bit more cautious, as we need to see structural changes to be implemented to boost growth prospects for Italy. With a rating that is very close to sub-investment grade, we still consider Italian government bonds as a tactical asset to hold rather than a long-term buy.
“The implicit assumption is that Draghi manages to keep his government together for this period, which should be possible considering the broad support team-Draghi has received also within Italy. According to polls, over 60% of Italians view his appointment as positive news, which bodes well for his current mandate.
“Market sentiment can also change on a dime for these bonds, so we are cautiously optimistic. Right now, Italian bonds are in a sweet spot, but their longer-term outlook is still very uncertain. Changes in the political, economic, or health situations will be important factors in altering the outlook and can send momentum in a different direction.”