Italy’s elections have produced political deadlock. But Italian bonds remain attractive, argues Kommer van Trigt.
Italian election deadlock prompts spike in Italian bond yields
Return to 7% yield levels not expected
Italian sovereign bond positions increased
Italian bonds are still attractive given their yields and the low yields in safer countries
ECB’s commitment to do “whatever it takes” still in place
Note: this article was updated on 5 March 2013 to reflect a change in portfolio positioning
Kommer van Trigt remains sanguine in the aftermath of Italian elections that delivered a political impasse, which pushed Italian bond yields sharply higher. “If broader financial-market panic is avoided and Italy maintains its access to funding, then we think that Italian bonds are attractive, given their yields and the low level of yields in safer countries,” says van Trigt, who oversees Robeco’s aggregated fixed-income mandates.
The ten-year Italian yield is now around 4.8%. That compares with less than 1.5% on German paper with a similar maturity.
In fact, after the market’s post-election sell-off, Van Trigt took advantage of an attractive entry point to increase his portfolios’ exposure to Italian bonds.
Markets were spooked by the prospect of prolonged political instability when it became clear that no clear winner had emerged from the 24-25 February elections and that it was extremely unlikely that a stable coalition could be forged.
Simply put, the elections produced a three-way split between Pier Luigi Bersani’s center-left coalition, which won a majority only in the lower house, comedian Beppe Grillo's Five Star movement, which ended up as the country’s largest party, and the Silvio Berlusconi’s resurgent center-right alliance.
Monti & austerity were the clear losers
If there was no clear winner, the loser was all too apparent. The austerity measures of humiliated former prime minister Mario Monti were unmistakably rejected. “Clearly, the message from the Italian public is that they are not satisfied with the way that the crisis is being handled,” says Van Trigt.
Given this political stalemate, how come Van Trigt is constructive on the prospects for Italian bonds? He acknowledges that a stable government with a strong mandate would have been a better result. But he notes that it was always highly unlikely that the elections would produce such an outcome. “Even a Bersani/Monti coalition with a majority in the Senate would have been unstable,” he says.
Moreover, even if a relatively robust coalition has appeared, his expectations for positive change would have been low. Looking at the potential governments that could have been formed in different circumstances, he would not have expected any of them to have tried as hard as Monti did in his first months in office to implement reforms. “Even he only achieved a little,” he observes.“We never expected a lot of progress in terms of faster reforms.”
Don’t forget positives such as the low budget deficit
His third point is that Italy’s economic situation is not as dire as it is sometimes painted. True enough, absolute debt levels are high. But there are positives, too. The need for further budget cuts in is low, he stresses. “Italy already has a budget deficit below 3% of GDP,” he notes. Moreover, private debt levels are low.
That’s not to say that the political paralysis hasn’t had some serious consequences. Van Trigt identifies two key negatives connected to the ongoing instability. First, Italy needs further reform to improve its growth outlook. It is hard to see how that will happen in the current circumstances.
Italy came through first funding test
Second, Italy needs to roll-over large amounts of debt. “With EUR 2 trillion of government debt, the annual roll-over needs are huge,” he says. Indeed, Italy is seeking over EUR 400 billion of fresh debt funding in 2013. The political turmoil is not going to facilitate the process. “It would be easier—and cheaper—without the political noise,” he says.
So, will investors continue to fund Italy? What can be said at this stage is that Italy came through its first major funding test on 27 February in decent shape. It succeeded in raising the EUR 6.5 billion it wanted, albeit with average yields higher than at the previous auction. The yield on the EUR 4 billion of ten-year bonds it sold averaged 4.83%; that compares with 4.17% last time. As has been the case for last couple of years, solid domestic demand saved the day.
While yields were higher, they are still nowhere near the 7%-plus highs seen in the panic of November 2011 or the slightly lower levels hit in July 2012. It appears that concerns over political paralysis are to some extent being offset by the ECB’s commitment to do “whatever it takes”.
That has been a crucial support throughout the crisis. “The ECB has helped the peripheral countries with liquidity support several times during the crisis,” says Van Trigt. He lists bond buying, the unlimited three-year loans to banks (LTROs) and the powerful but as-yet-unused commitment certain circumstances in to buy bonds issued by peripheral countries in the secondary markets (the OMT/outright monetary transactions).
No return to 7% yields expected
Nor does Van Trigt envisage Italian yields returning to those 7% highs. “We are not convinced that we will see in the short term a repetition of what happened to Italian bonds in late 2011 or last summer,” he says. “Our base case is more a muddle-through scenario. We will move from crisis to crisis, while the central bank will try to smooth the process. Markets will remain vulnerable to political events.”
Van Trigt thus maintains his long-held view that volatility in peripheral countries will remain high. As an active manager, that is something his portfolios can benefit from.
What about the OMT’s “strict and effective conditionality”
Still, more extreme scenarios cannot be ruled out. It is by no means Van Trigt’s base-case scenario, but what if the situation deteriorates badly and Italian yields do rise back up to 7% levels, necessitating a bail-out?
What’s important here given Italy’s current situation is that the ECB's OMT schemeinvolves "strict and effective conditionality": in plain words, a rigorous reform program with IMF involvement. How could that work when Italy has no stable government in place to request a bailout or to negotiate with, and when voters have so decisively rejected austerity?
“This will be harder now, as there is no Italian government yet to sign a memorandum with the ESM,” concedes van Trigt. “But in the end, policymakers have always bowed to market pressure and circumvented rules or invented new tools to provide liquidity support.”
If push comes to shove, then, policymakers will do whatever is necessary to ensure a rescue? “Don’t underestimate the commitment of policymakers to stabilize the situation,” he says.
Exposure to Italian bonds increased
In sum, then Van Trigt expects Italian bonds to be volatile but not for market panic to set in. Moreover, Italy is maintaining its access to funding, yields are at appealing levels and the bonds remain supported by the ECB’s commitment—in certain circumstances—to buy bonds of so-called peripheral countries such as Italy.
The portfolios Van Trigt manages reduced their holdings of Italian paper ahead of the elections because of the event risk. Now, though, he has increased his portfolios’ exposure to Italian bonds again.
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