In the space of two weeks, Italian government bond markets have gone from calm and complacency to levels reminiscent of the eurozone sovereign crisis. Whilst political uncertainty is not new to Europe, let alone Italy, the expected formation of a ‘super’ populist government between Five Star Movement and the League with a clear Eurosceptic leaning has sent shockwaves through markets and investors running for cover.
In spite of the Italian parties stepping back from talk of leaving the Eurozone, debt forgiveness and parallel currencies, government bond markets have seen yields rise by 140 basis points (bp) in the ten year part of the curve and more worryingly over 250bp at the front end of the curve (two years to maturity) at their worst point. This flattening of the yield curve is symptomatic of investor fears around a sovereign default albeit the yield levels currently observed suggest this is not a serious risk factor yet.
Worryingly, however, the market seems entirely one sided (in risk-off mode) with little interest to stem the selling in the more panicky moments. With political uncertainty set to continue, it is not clear at what point we will see stability in Italy. This is a serious matter for investors; Italy has the third largest sovereign bond market in the developed world and is far too big to fail.
A Eurosceptic government at loggerheads with the European Commission and a much increased cost of debt spells trouble for Italy’s debt sustainability calculations. What matters for Italy will ultimately matter for the world, hence we have seen good demand for safe haven government debt over the past week, with bunds, gilts and US Treasuries all lower in yield.
Tim Winstone, portfolio manager, credit
European credit markets have continued to be under severe pressure on heightened political fears in Italy. A weakening in the political backdrop in Spain since Friday, on the back of the Spanish Socialist party filing a no-confidence motion against current Prime Minister Rajoy, has also further negatively impacted market sentiment.
The past few weeks have seen credit spreads of investment grade corporate bonds of Italian issuers widen significantly. Banks such as Unicredit and Intesa Sanpaolo have seen a rise in spreads (bid Z-spread*) over the month in their investment grade rated senior bonds of 217bp and 211bp respectively.
Names within high yield have suffered more than their investment grade counterparts given the high beta nature of the former. For example, long-dated bonds in BB rated Italian telecommunication company Telecom Italia have delivered negative excess returns month to date of -16.0%. The spread between Italian and German government bonds has also widened dramatically, reaching levels not seen since 2013.
However, this instability has also been felt more broadly with most of the market also widening in sympathy. In fact, sterling investment grade credit spreads have widened by 18bp month to date, while US investment grade bonds credit spreads have moved wider by 6bp (spread to worst versus government). We have also seen a slowdown in the European and US primary markets as weakness in secondary bonds combined with the broader macroeconomic concerns has deterred issuers from entering the market. It is likely markets will remain volatile and sentiment weak as the Italian political backdrop remains fragile and unresolved.
Published by Andrew Mulliner and Tim Winstone, Portfolio Managers at Janus Henderson Investors
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Source for above data on spreads and returns: Bloomberg, at 30 May 2018
*The Zero Volatility or Z spread is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where the cash flow is received.