23 Jun 2022 4 min read

Italian debt: could risk premiums be returning to peripheral bonds?

By Corinne Lewis-Reynier , Marc Rovers , Simon Bell

During a testing period for non-core European credit, we explore if now heralds the return of opportunity in Italian debt.

 

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The last few weeks have been testing for European government and credit markets – and for Italian sovereign debt, in particular.

During the European Central Bank (ECB) meeting in June, president Lagarde's language was too vague for the markets' liking and did not address the lack of progress on possible tools they could use to limit the widening of Italian spreads versus German bund yields. This rattled European markets - and rattled them hard.

Meanwhile, inflation is raging through key economies. The UK, US, and Eurozone all have annual inflation at or above 8% and rising, and it is unclear how drastic policy measures will need to be to contain it.

At the 9 June monetary policy meeting, the ECB President, Christine Lagarde, confirmed that a 25 basis point rate increase would be on the cards in July. Reacting to a sharp increase in the central bank’s inflation forecast, she also said the ECB expects to raise interest rates by 50 basis points in September, with more increases to follow.

Right up to the ECB meeting, yields on Italian government bonds (aka ‘Buoni Poliennali del Tesoro’, or BTPs) were steady, at around 3%.

However, things quickly started to unravel afterwards, with markets pushing the Italian government’s borrowing costs to beyond 4% – a move reminiscent of the market stresses seen during the 2011 European sovereign debt crisis, as the chart below shows:

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Even the yield on 10-year German government bonds (aka bunds) rapidly rose to above 1.75%. Bunds are generally seen as almost risk-free and are used as benchmarks for government debt across Europe.

We can see some context for the move in Italian bonds by charting the spread (difference in yield) between German and Italian bonds. These spreads reached a high of 250 basis points soon after the meeting, but this is barely half what they reached in 2011. The chart below shows this:

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Then, only a few days after their rate-setting meeting, the ECB announced an emergency meeting on 15 June to look at an ‘anti fragmentation tool’ to support peripheral government debt, in particular Italian bonds.

This was enough to provide some much-needed relief to the European markets, with yields on BTPs lower on the day of the announcement and the spread between Italian and German bonds soon falling back to its pre-meeting level of below 200 basis points.

So far, the proposed details of the relief package have been at the higher end of expectations:

  • There was a quick turnaround in time for the July meeting
  • We saw light levels of conditionality – the package relies upon conditions set for Next Generation EU (aka the European Union Recovery Instrument, an economic recovery package set up to support the EU member states during the COVID-19 pandemic). All players have pre-qualified for these measures
  • They appear to be moving away from vague ‘market stress’ language to targeting set spread levels to encourage buying

Given the build-up in expectations, there is also a good deal of scope for disappointment if these tools cannot be agreed and become open to a legal challenge that could take years. For now, the market is taking comfort that this has effectively put a ceiling on Italian-German spreads.

Overall, if the ECB can convince the markets they can stamp out spread widening, hiking in greater increments may become more straightforward.

In the credit space, there hasn’t been a discernible premium attached to peripheral issuers for some time, especially in non-financials – partly due to the ECB’s corporate bond-buying programme.

The recent repricing of peripheral bank bonds and Italian corporates means some of that premium has returned, which in our view has begun to create some more interesting investment opportunities.

At this stage we don't know what the ECB will announce. However, even in the new paradigm where monetary support is lifted in the form of rate rises and quantitative tightening, recent events have indicated that central banks have got the markets' back.

At least for now.

Corinne Lewis-Reynier

Head of Investment Specialists, Active Strategies

Despite hailing from the south of France, Corinne has always been more interested in the intricacies of global finance than sunshine and the beach. This meant she built a career in the City of London career where, despite growing to enjoy tea, the British weather, fish and chips, and Jaguar E-Types, she has retained a preference for Gallic cheeses and ciders.

She joined LGIM in 2018 and previously worked at BlackRock, where she was Head of European product specialists for short duration strategies. She has also worked at Morgan Stanley Investment Management as a senior portfolio manager, and started her career at JP Morgan Asset Management, where she was a portfolio manager and government bonds trader. Corinne earned an MA in Financial Risk Management from the University of Aix-en-Provence and a Master’s degree in International Economics from the University of Sussex. Corinne holds an MBA from London Business School.

Corinne Lewis-Reynier

Marc Rovers

Head of Euro Credit

Marc is head of the euro credit portfolio management team. He joined LGIM in May 2012 as a portfolio manager in the Pan European Credit team. Marc previously spent 12 years at BlackRock, first as a senior portfolio manager within Philips Investment Management in Eindhoven and then as Director, Investment Manager in London, where he was responsible for the management of non-financial investment grade portfolios and a portfolio manager for two Asian credit portfolios. Marc started in the industry in 1995 as a portfolio manager at ABP investments (now APG). He graduated from Tilburg University, Netherlands with an MSc in economics and is a Certified European Financial Analyst (CEFA).

Marc Rovers

Simon Bell

Fund Manager

Simon is a fund manager within the Active Fixed Income team, where he manages global rates portfolios. He joined LGIM in 2012 from Aberdeen Asset Management where he had a similar role, prior to which he was involved in LDI and trading, with a total of 20 years' investment experience. Simon graduated from Bournemouth University with a BA (hons) in Financial Services and holds the IMC.

Simon Bell