Italian BTPS: simply irresistible
Fixed Income Strategist
Summary: We believe that Italian BTPS are oversold, and they now offer exciting buy-to-hold opportunities compared to peers. For savers, they provide an instrument to avoid negative deposit interest rates since they pay a positive yield starting from four years. At the same time, they offer one of the most compelling risk/reward ratios in the European bond market for real money. BTPS linkers are also the cheapest inflation protections that one can find in the euro area. Additionally, tapering and political fears driving the selloff in BTPS will prove unfounded in the short term. Everything points out that sovereigns of other European countries are expensive and need to reprice accordingly. Most likely, Greek, Portuguese and French government bonds are going to be the casualties.
Three elements are driving losses in Italian government bonds:
1. The market fears that the European Central Bank may taper purchases under the pandemic emergency purchase programme (PEPP) program, of which Italy is one of the biggest beneficiaries.
News that the Hungarian central may hike interest rates in June before tapering purchases under the quantitative easing program provoked a broad selloff in European sovereigns. News come in a moment in which other central banks have started to tighten financial conditions as well in light of rising inflationary pressures. Thus, investors fear that the ECB will follow this trend and begin to taper purchases under the PEPP starting next month as the central bank reviews the program.
Such possibility pressured investors to dump Italian BTPS as the country is one of the biggest beneficiaries of purchases under the PEPP program.
However, we believe that these fears are unfounded, and BTPS will continue to be supported by the ECB's accommodative monetary policies.
One of the main reasons why investors believe that the ECB can start to tighten financial conditions is that real rates remain stable as nominal yields rise. In February, when the ECB communicated that it would increase purchases under the PEPP program, nominal yields were rising together with real yields, tightening financial conditions. However, now that German real yields are stable, real yields of other European countries are rising, tightening economic conditions in specific geographical areas. Therefore, we believe that the ECB will need to continue to support financing conditions through a stable or increased pace of bond purchases under the PEPP program to support the economic recovery in these countries.
The lower panel of the chart below shows French and Italian real rates. It is not random. Investors are focused on Italy because of the bad reputation the country gained during the European sovereign crisis. However, investors turn a blind eye on France, which public debt surpassed Italy in March last year. Not only, but french private debt has also exponentially risen, putting the country's economy in a delicate situation. Although French government bond yields remain close to zero, ten-year French OAT yields rose 65bps since December's lows, to the highest in two years. In comparison, Italian 10-year BTPS yields rose by roughly the same since February's lows. Still, yields remain in line with those of July last year, making the country less vulnerable than France to a further rise in yields.
France is even a more significant beneficiary of the ECB's bond purchases under the PEPP program than Italy, making it even more exposed to tapering risk.
2. Political uncertainty remains and will continue to be a recurrent problem.
Uncertainty within the Italian political scene has always been an issue. Thus, we are not surprised that there are some hiccups also with Mario Draghi at the government.
The main problem is that the current government is a coalition of many diverse parties, including the PD (Democratic Party), 5 Star Movement, Forza Italia, the Northern League and other minor centre and centre-left parties. Mario Draghi is poised within this very fragile equilibrium to enact key reforms demanded by the European Union. However, Matteo Salvini, head of the Northern League, recently said that the current government would not have a chance to enact such reforms. His party is looking to push Draghi to the country’s presidentship at the beginning of 2022, forcing the country into an early election.
Such a scenario can be concerning because Salvini’s Northern League party is leading recent polls (21%). Polls also suggest that the second biggest party is Brothers of Italy, a national far-right conservative party led by Giorgia Meloni, which is gaining support by the day. Therefore, it opens up to the possibility that Eurosceptics will lead the next Italian government, which would make the relationship with the EU problematic.
In our opinion, the political backdrop of the country remains solid as long as Draghi is Prime minister. Although a conservative government represents a threat, we believe it’s too early to price it in BTPS as things can rapidly change.
3. The economy is gradually opening
As the economy reopens and restrictions are lifted, we can expect growth to pick up. Higher growth and sustained inflation levels imply that the central bank will need to withdraw stimulus and eventually hike rates gradually. This is why news of a successful Covid-19 vaccination campaign and the economy reopening sends interest rates up.
Italian BTPS are becoming more and more desirable
As BTPS offer higher and higher yields, the more compelling they become compared to peers for the following reasons:
- Smaller investors will look to use BTPS to park cash to avoid negative interest rates on deposits. Italy is the only European country offering a positive yield starting from four years up. To secure a positive yield in Portugal and Spain, one will need to go beyond a 6-year maturity. French OATs pay a positive yield from eight years onward.
- Real money will find it difficult to find better risk/reward in the European bond space. Investors with long-term investment horizons such as pension funds and insurances will find that Italy is currently offering the highest yield in the European region. Italian BTPS provide even a higher yield than Greek government bonds, which are rated junk. Ten-year BTPS pay 1.1%, while 30- and 50-years bonds pay a solid 2% and 2.5% in yield. In comparison, according to Bloomberg Barclays indexes, high yield EUR corporate bonds offer an average yield of 2.5% for three and a half years duration. Investment-grade EUR corporate bonds provide on average a yield of 0.38% for an average duration of six years.
- Italian inflation linkers are less expensive than peers. As inflationary pressures are resurfacing, investors are looking for protection. Unfortunately, investors will find European inflation linkers incredibly expensive, with Germany providing a negative yield of almost -2%. Within this context, Italian inflation linkers shine. Ten-year Italian inflation linkers BTPS provide a slightly negative yield of -0.2%, allowing investors to get protection cheaply compared to other EUR linkers.
When looking at Italian BTPS, it is essential to understand that yields are destined higher precisely like all other European sovereigns. It means that all sovereigns in the euro area, including Italian government bonds, will lose value. Therefore, it is necessary to look at BTPS as a buy-to-hold opportunity. Within this context, investing in European sovereign ETFs could prove dangerous. Indeed, the mark-to-market value of the fund's holdings will continue to fall, while their ultra-low coupon payments will not balance out losses.
We cannot get over Italian BTPS.
As we have highlighted in an earlier analysis, the risk of rotation from European sovereigns to the US safe havens is a concern. Although European yields have risen, the pick up that countries such as Greece offer is marginal compared to the yield provided by EUR-hedged US Treasuries, despite bringing obvious liquidity and credit problems. When looking at Portugal and Spain, the pick-up that EUR-hedged US Treasuries offer becomes even more significant.
Within this context, we believe that Italian BTPS are oversold compared to peers. The higher their yield, the less exposed they will be to rotation risk.
In short, we are welcoming the rise in yields in Italy but are afraid that the increase in yields in the rest of the eurozone will be much more brutal.