Fear mounts on Italian bonds - to avoid or to conquer?

Something very important which was put aside last week following the US sell-off was the dreadlock situation in Europe between Italy’s anti-establishment government and the European Union.

The Italian 10 Year government bond yields rose to 3.53% from 2.808% a month ago and spreads over German yields widened sharply. That is an increase of 25%!. The FTSEMIB, which is heavily weighted in banking stocks, also suffered a lot lately.

Most of this pressure on Italian bonds and banking stocks came about after the Italian government agreed for a budget deficit to 2.4% of gross domestic product, defying EU demands to rein in spending.

Although a lot of fear is being mounted on the fact that Italian debt is unsustainable and that we might have a eurozone breakup, I think that this has actually given us an interesting investment opportunity in Italian government debt.

Why it this so?

Eurozone borrowers are quite unique. While each nation issues its own debt, all 19 of them share the same European Central Bank.

We might remember that back in 2010-2012, there were a lot of fears that Italy, Spain or Portugal would be kicked out of the Eurozone. This has led to higher spreads. As we can see from the below chart, the 10 YR government spreads between Italy and Germany rose to around 5.5% but then started its decline after the famous “whatever it takes to save the euro” speech by Mario Draghi.

Same thing happened in Greece – investors who bet after the crises in 2015 have amassed large amount of gains.

Coming back to the deficit situation, public debt in Portugal and Spain remains huge although investors don’t seem to care. The reason is that as long the eurozone doesn’t break up, sovereign debt will always be paid.

What we really need to consider is that the spreads are not really measuring the risk of default, but really the fear of a country leaving the Eurozone. If this happens, it would mean that the investor will be paid back in Italian Lira or Spanish Pesetas. Something which will surely provide a dramatic exchange rate loss.

A recent study by the Eurobarometer showed that 59% of Italians support the common currency. This is the lowest % in the bloc, however still a clear majority which gives us re-assurance that for the time being the risk of a euro break up is not on the cards. Even the painful budget cuts that the EU imposed on Greece weren’t enough to get sufficient support to leave the eurozone.

Based on this rationale and the fact that equity markets are starting to look less stable, I think that Italian government bonds provide a good level of return with minimal risk in the current environment.

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