Bloomberg News

Italian Bonds Fall From Grace on Contagion Concern

July 06, 2012

Italian Bonds Fall From Grace on Contagion Concern

Italy has pledged to reduce its budget deficit to 1.7 percent of gross domestic product this year and trim it to 0.5 percent in 2013. Photographer: Alessia Pierdomenico/Bloomberg

Italian bonds turned a first-quarter rally into the third-worst performance in Europe as concern mounted that government leaders won’t prevent the debt crisis from spreading to the region’s biggest fixed-income market.

Italy’s debt had the second-best returns after Portugal of the 17 euro-area nations in the three months through March and then handed investors a loss of 2.2 percent in the past quarter. Italian bonds fell for a third day with the 10-year yield rising 9 basis points to 6.07 percent after European Central Bank President Mario Draghi said yesterday a cut in interest rates to a record low may offer little help as the euro-area economy slides toward recession.

The government led by Italian Prime Minister Mario Monti approved 4.5 billion euros ($5.6 billion) of spending cuts for this year and 26 billion over three years as part of a broader plan announced early today to trim the size of the public administration and stave off further tax increases. The rise in yields has hampered efforts to lower the nation’s 1.9 trillion euros of debt.

“The political fraternity has done nothing to get Italy onto a path where its potential growth rates in the future would make one confident that it could gradually start eating away at that debt mountain,” said Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London.

Italian bond yields fell after the ECB said in December that it would offer unlimited three-year loans to euro-area financial institutions. The 10-year rate was as low as 4.68 percent on March 9, down 280 basis points from the Nov. 9 euro- era record of 7.48 percent.

Spanish Banks

Even as the ECB helped boost Italian bond returns in the first quarter, the country’s budget deficit increased. Italian yields climbed in the second quarter as Spain was forced to request as much as 100 billion euros ($125 billion) to help recapitalize its banks.

Yields on both nations’ 10-year debt then slid in the days following the June 28-29 summit of European leaders in Brussels, which paved the way for debt relief for Spanish banks. Spain’s benchmark rate was at 6.9 percent at 9 a.m. in Madrid, down from 7.01 percent on June 28.

The ECB sought to maintain the stimulus momentum yesterday when policy makers cut the region’s key interest rate to an all- time low of 0.75 percent from 1 percent.

“We still expect a gradual, slow recovery around the end of the year,” Draghi said at a press conference in Frankfurt, adding that the interest cuts will reduce the cost of central bank loans for struggling banks. “The baseline scenario hasn’t changed, although the downside risks are now materializing.”

Yield Gap

The extra yield investors demanded to hold Italy’s 10-year debt over similar-maturity German bunds surged to as much as 490 basis points, or 4.9 percentage points, in June, up about 200 basis points from their March low. It was at 469 basis points today.

“There is a possibility we could see a 5 percent spread versus 10-year government bonds by the end of the summer,” said Yannick Naud, a London-based portfolio manager at Glendevon King Ltd., who helps oversee $163 million in assets.

Italy’s high level of government debt and low growth make it more vulnerable to Europe’s financial crisis than other euro members, the European Commission said May 30. The Mediterranean nation is mired in its fourth recession since 2001. It also will post the second-highest debt, according to commission forecasts.

Italy has pledged to reduce its budget deficit to 1.7 percent of gross domestic product this year and trim it to 0.5 percent in 2013. The country had the third-worst performing bond market after Greece and Spain in the three months through June as Monti’s administration was forced to push back deficit- reduction targets.

European Whirlwind

“There was a looming feeling that Italy was going to get caught up in the whirlwind of stress that affected so many other of the weaker economies in the euro zone and that’s what has been undermining Italian debt over recent weeks,” said John Wraith, a fixed-income strategist at Bank of America Merrill Lynch in London. “Their macro data has taken a turn for the worse. There are persistent stories that Italian voters are starting to lose patience with a technocratic government.”

Monti’s popularity with investors was damaged after he passed watered-down labor-market legislation on June 27. He was forced to temper proposals to revive Italy’s economy by making it easier for distressed companies to fire workers after Italy’s biggest union called a general strike and a key political ally vowed to oppose the bill.

Concern that Monti will be unable to cut spending and boost the competitiveness of Italy has driven borrowing costs at auctions back to 2011 levels. The euro-region’s third-largest economy paid the most to sell 10-year debt since December on June 28.

“It’s self-fulfilling,” Glendevon’s Naud said. “Every day you have to pay high interest to refinance your existing debt. Slowly that should put pressure on Italian government bonds.”

To contact the reporter on this story: Lucy Meakin in London at lmeakin1@bloomberg.net.

To contact the editors responsible for this story: Daniel Tilles at dtilles@bloomberg.net.


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