(Bloomberg) —
At least judging by Italian bond markets, investors are unfazed by the prospect of a right-wing coalition taking power after Sunday’s snap elections. But many fear the calm won’t last long.
Government debt has been ramped up in a broader wave, pushing the cost of 10-year government bonds to levels last seen in 2013. But Italy’s yield premium over Germany, a measure of idiosyncratic risk, is still lower than it was at the beginning of the month. suggesting that bondholders don’t expect the closely watched election to cause much turmoil.
The appetite for Italian corporate bonds hasn’t waned either, which have fared less badly this year than most European corporate peers, according to Bloomberg data. And just 10 days before the vote, gambling company Lottomatica SpA raised 350 million euros ($340 million) on the bond markets, receiving three times more orders than that amount, despite its poor credit rating.
What has kept volatility in check so far is the coalition’s pledge to honor budget commitments made to the European Union. The risk is that the promise will turn out to be hollow and the coalition will sharply increase spending. That would jeopardize hundreds of billions of euros in EU funds, just as Italy faces a blackout and economic recession.
“If you look at their policy agenda and they end up doing what they say, there will be massive fiscal expansion,” said Axel Botte, global strategist at Ostrum Asset Management.
Throw promised tax cuts into the mix and the public deficit would soon “clash with previous commitments to the EU,” Botte said, advising clients to stay tight in Italy.
Read more: Italy’s welcome gift to Meloni will be worsening economic outlook
corporate fears
Policies moving away from alignment with the European Union would only add to the list of concerns for local borrowers already facing rising inflation and falling central bank support.
For companies already facing higher borrowing costs, losing access to EU post-pandemic recovery funds would prove disastrous; Bloomberg Intelligence chief credit strategist Mahesh Bhimalingam warns this could trigger debt defaults and rating downgrades.
A strong hit to junk-rated Italian borrowers could resonate throughout the system. In fact, Italian companies make up over 16% of Bloomberg’s European High Yield Index, more than any other country on the continent.
Those fears played out in construction firm Webuild SpA’s bonds this week. They fell more than 4.5 cents against the euro after Giorgia Meloni, likely the next prime minister, told Italian media that the EU’s recovery plan needed fine-tuning.
“We cannot risk having transfers suspended or even halted,” Webuild Chief Executive Officer Pietro Salini told an industry event this week, urging political leaders to comply with the framework and terms of the reform package agreed with the EU.
The weakest link
With high levels of debt, sluggish growth and volatile politics, Italy has long been considered Europe’s weakest link. And there is plenty of precedent for election-related volatility – a vote in 2018 that sparked concerns about the future of Italy’s euro membership burdened bond investors with their biggest monthly losses on record.
Breaching the spending pledge and increasing bond market funding would worsen Italy’s debt ratio, which at 151% is already the second highest in Europe.
And after years of easy money, capital is becoming more and more expensive. Money markets see a nearly 85% chance of the European Central Bank raising interest rates by 75 basis points in October. Policymakers are also considering how best to reduce the ECB’s huge balance sheet.
Still, higher borrowing costs would not pose an immediate threat to Italy, which has taken advantage of years of extremely low interest rates to extend the average life of its debt beyond seven years. But borrowing at much higher yields for an extended period would eventually take its toll, said Stephane Monier, chief investment officer at Lombard Odier Private Bank.
“Italy did the right thing and extended the maturity of its debt. But it also depends on how the economy is doing: if there is a recession that lasts several years, the situation is much more precarious,” he said.
Monier said he would only consider buying more Italian government bonds if the yield spread over Germany exceeded 300 basis points. It stood at 232 basis points on Friday, more than 10 basis points below June’s two-year high.
mitigation factor
One factor mitigating investor concerns is that the ECB will continue to divert proceeds from its pandemic-era bond portfolio into buying debt from southern European countries until at least 2024. Their new instrument, the Transmission Protection Instrument, aims to mitigate unjustified credit jump costs for weaker eurozone members.
Still, investors may be putting too much faith in this backstop. Rather than being a bailout facility for Italy, it should be seen as a means of preventing contagion across the bloc, Ostrum’s Botte said.
Botte also warned that the coalition between Meloni’s Brothers of Italy party, Matteo Salvini’s Lega and Silvio Berlusconi’s Forza Italia looks fragile.
“They have different views on how Italy should be,” he said. “We’re not ruling out an open crisis at some point if those parties can’t hold it together.”
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