Monday, June 5

Italy Bond Market Calm to Face Stress Test as Rating Risks Junk


(Bloomberg) — This year’s extraordinary calm on Italian bond markets is about to be tested, as a possible demotion to junk credit status and Europe’s tighter financial conditions threaten a rise in borrowing costs.

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(Bloomberg) — This year’s extraordinary calm on Italian bond markets is about to be tested, as a possible demotion to junk credit status and Europe’s tighter financial conditions threaten a rise in borrowing costs.

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The first test is due within hours, when Moody’s Investors Services decides whether Italy’s sovereign rating should be lowered from the current Baa3. A downgrade would mean Moody’s rates Italy below Romania, and in the so-called junk category that includes Greece and many emerging markets such as Brazil.

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To be clear, a Moody’s cut would still leave Italy with investment-grade ratings from the two other major agencies, a key factor for many funds’ allocation decisions. But even if a downgrade is averted, other problems beckon.

The European Central Bank will soon require euro area banks to start repaying the €500 billion ($550 billion) in cheap pandemic-time loans, with Italian lenders owing a hefty chunk. Not is it expected to flinch from further interest-rate increases, even as it keeps winding back bond-buying stimulus.

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“Short term, there are some risk events that keeps us prudent on Italy,” said Nicolas Forest, head of global fixed income at Candriam SA. “Growth has proven resilient but fiscal challenges remain important for Italy and need to be closely monitored.”

Still, a key measure of risk for Italian bonds — the yield spread over 10-year German notes — has been stable this year around 190 basis points, well below last year’s highs above 250 basis points.

That’s due to Italy’s recent economic surge, and greater fiscal restraint from Prime Minister Giorgia Meloni’s right-wing government than investors had expected when it took office last September. Many also credit the ECB’s anti-crisis tool — introduced last year , it provides for unlimited bond-buying in times of stress.

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Read More: Why Europe Has a New Weapon for Bond ‘Fragmentation’: QuickTake

Known as the Transmission Protection Instrument (TPI), the backstop hasn’t yet been deployed, but its very presence appears to have helped cap regional borrowing costs. Without the TPI, Italy-Germany spreads would be at 250 to 300 basis points, Miz u ho strategist Evelyne Gomez-Liechti reckons.

“The political backdrop was difficult, but spreads didn’t move violently wider,” she said.

What Italy needs now is faster economic growth to shrink its debt burden, which stands at a staggering 140% of GDP. However, Rome is struggling to allocate and spend hundreds of billions of euros in EU funds, crucial to speeding up the economy.

Finally, servicing this mammoth debt is becoming costlier. The ECB has lifted rates by 375 basis points over the past year, and will likely raise them another half-point to 3.75%.

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Rating

The more immediate focus is Moody’s, which said recently Italy was the only country liable to losing its investment-grade rating.

A downgrade would widen the Italy-Germany yield spread by 50 basis points, Citigroup Inc. strategists, including Jamie Searle, estimate.

It would also raise fears of follow-through from other agencies. That would risk Italy’s membership of bond indexes tracked by funds managing trillions of euros in investment. Many benchmarks exclude countries rated sub-investment grade by two main agencies .

“(Spreads) could widen sharply as the market quickly prices the risk of exclusion from bond indices,” Citi noted.

More downgrades don’t look imminent however. Fitch Ratings last week affirmed Italy at BBB — a notch above Moody’s — and with a stable outlook, indicating a change is unlikely for now. S&P Global Ratings too has affirmed Italy at BBB.

Read More: Italy Survives Fitch Judgment in Boost for Meloni Before Moody’s

Goldman Sachs economist Filippo Taddei is among those expecting Moody’s to hold off a downgrade on Friday. Taddei, as well as the Citi team, even flags the possibility of an outlook upgrade to stable from negative, as risks of a growth downturn and energy crisis is fade in Italy.

That could see the spreads tight 20 basis points, Citi predicted.

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