By Sunny Oh
VINCENZO PINTO/AFP/Getty Images
After this week’s selloff in Italian sovereign debt, 90% of the country’s high-grade corporate bonds now earn a lower yield than government paper, according to an analysis by Bank of America Merrill Lynch.
In other words, investors appear to view Italian corporate bonds as less risky than their government peers.
That flies in the face of the expectation that governments are more creditworthy than corporations. Backed by the full faith and credit of the government, with its tax-raising abilities, government debt should usually feature a lower yield than those offered by corporate debt to reflect a lower risk of nonpayment. Even in countries without gold-plated credit ratings such as France and Spain, nearly all of their government bonds trade at a lower yield than their corporate counterparts.
“In the credit market we’ve been struck by the extreme relative value gap that’s opened up between Italian [corporate credit] and Italian sovereign debt during the last week. Italian credit spreads have held up incredibly well vis-à-vis [Italian government paper], amid the volatility,” said Martin Barnaby, head of European credit strategy at Bank of America Merrill Lynch.
The Italian 10-year government bond yield /zigman2/quotes/211347230/realtime BX:TMBMKIT-10Y +0.54% climbed to an intraday high of 2.555% Friday, the highest since August 2014, versus 1.740% on May 3, according to Tradeweb data. Bond prices fall when yields rise. Worries about Italy have weighed on the euro /zigman2/quotes/210561242/realtime/sampled EURUSD -0.1642% , which fell 0.9% versus the dollar this week, while the FTSE MIB stock /zigman2/quotes/210598024/delayed IT:I945 -2.97% shed 6.6%.
Much of the selloff in Italy’s bond market came in the last two weeks as the anti-establishment Five Star party and the far-right League made progress toward forming a coalition government after weeks of deadlock following an inconclusive March general election.
The coalition’s fiscal agenda has raised fears further budget-widening measures could add to Italy’s debt pile, stoking fears of a return of the eurozone crisis and a heightening risk of default. Some of their proposals include billions of euros in tax cuts, increased spending on social welfare, and a pushback on pension reforms.
And the recent pain for Italian bondholders may be nothing compared with what would happen should credit ratings firms sours on its sovereign debt. Analysts at Société Générale says investors will run for the exit the closer Italy’s government bond rating approaches “junk,” which would push more conservative investors to expunge it from their portfolios.
Moody’s has placed a negative outlook on Italy’s sovereign debt for two years, meaning a downgrade may arrive in the next few months. Slashing its current Baa2 rating to a Baa3 rating would leave its one notch above “junk”, a move that would “make the recent selloff look very minor indeed,” said Keven Ferret, a rates strategist for Société Générale.
But Barnaby says a situation where Italy’s corporate bonds are priced as less risky than government paper is unlikely to last.
He blames the ramp-up of the European Central Bank’s corporate bond buying program for creating this unusual state of affairs. At its current pace, the ECB is on track to snap up 4.9 billion euros ($5.71 billion) of corporate bonds in May, after a quiet April saw the central bank buy 3.1 billion euros. The corporate bond purchases are part of the 30 billion euro a month program of bond buys that are scheduled to continue at least through September.
Barnaby said the ECB has recalibrated bond purchases in favor of corporate debt at the expense of government paper. “The ECB has upped the intensity of its [corporate bond] purchases lately, especially with regards to Italian issuers,” he said.
Market participants have highlighted that the ECB’s quantitative easing has pushed yields even in the more default-prone high-yield sectors so low that the implied rate of nonpayment is negligible.
“Credit investors should tread carefully with respect to Italian credits at present. While corporate credit richness versus government debt can persist, we learned during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider versus government debt,” said Barnaby.