Senior Fixed Income Strategist, Saxo Bank Group
Summary: Italian sovereigns are better positioned to benefit from a "Draghi effect" compared to corporate bonds if the former President of the European Central Bank is appointed Prime Minister of Italy. The 10- and 30-year BTP-Bund spread have the potential to tighten to test 2015 lows of 100bps and 120bps respectively representing a capital gain up to 7%. Finally, BTPs will benefit from the BTP-Bund spread compression regardless of Draghi. Nevertheless, in a non-Draghi scenario, the tightening will be gradual, forcing investors to hold on BTPs for longer.
I have written a lot about Italian sovereigns explaining why I like them compared to other European peers. However, I have never touched upon probably their most bullish scenario: Mario Draghi, the most dovish President the ECB has ever had, becoming Prime Minister.
Although it seems that a new majority led by Giuseppe Conte will be the most probable outcome, the market cannot discard the probability of a technical government led by Draghi. Such a result will send a pro-European signal provoking a fast tightening of the BTP-Bund spread. At that point, the only question will be "how much upside is there in BTPs"?
We believe that a temporary solution to the Eurosceptic threats coming from the Northern League and the Brothers of Italy parties will push the BTP-Bund spread to 2015 lows: 100bps and 120bps for the ten- and thirty-year spreads, respectively.
Specifically, the tightening of the BTP-Bund spread will translate into a 12 bps fall in 10-year BTP yields representing an upside of around 1%. As per the image below, this would be a move of equal intensity as seen last June, when the country was exiting from the first Covid pandemic wave. Yet, ten-year yields could potentially dive further falling as much as 19bps as seen last May, giving an upside of approximately 2% to 10-year BTP holders. Longer-term BTPs will benefit the most falling as much as 30bps representing a capital gain of roughly 7%. Still, their tightening will be more gradual, and this strategy will require investors to hold these securities for a more extended period.
Italian corporate bonds will also benefit from the news, but less than the county's government bonds as they trade inside the government debt. According to the Bloomberg Barclays Euro-Aggregate Italy Corporate index, they offer an average yield of merely 0.3%.
What happens if Draghi doesn’t become Italy’s PM?
No worries! The spread between the BTP and the Bund will continue to tighten irrespectively of Draghi. However, if the former President of the ECB becomes Prime Minister, the news would give an instantaneous boost to the BTPs. Otherwise, the tightening will be constant, but gradual as the ECB will be forced to add more stimulus to support the European economy. Indeed, the ECB will be the only game in town as a new fiscal package will not come while Germany goes through government elections.
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