Summary: As bond issuance has slowed this year, Italian corporates are finally starting to feel the liquidity squeeze of higher funding costs. But pockets of relative value are still to be found – if you look hard enough.
The Christmas season is notoriously preceded by the flu season.
It has been scientifically proved that influenza is caused by viruses. However, Italians reject this scientific fact and instead blame the flu on the infamous “colpo d’aria” which translates into “hit of air”.
This “hit of air” is indeed incredibly dangerous and infects many Italians of all ages, which is why Italians tend to be in constant fear of fresh air and take great pains to avoid it, something which is extremely difficult to do. In restaurants they object to sitting in a draught, during winter they cover every part of their body with wool or down and most importantly, after showering they must dry their hair straight away otherwise the hit of air will hit their head and they might catch a “cervicale”, another disease that exists only in Italy, but can be compared to neck pain. An excruciating, tragically painful, Italian-style neck pain.
Without going further into investigating Italy’s peculiar health hazards, it is safe to say that the “colpo d’aria” phenomenon even affects the Italian economy. With blows coming from the north, from the European Commission, Italian BTPs have being falling since the beginning of the year, thereby increasing the risk that the overall Italian economy will catch a cold.
The Bank of Italy recently compiled a report that assesses the financial stability of the country and alerts us to the possibility that in the next few years the economic situation of the country will worsen.
The biggest contributors to such a prediction are high Italian BTP yields. As you can see from the chart below, Italian 10-year BTP yields are trading at a four-year high. In 2016 they touched a low of 1.04%, meaning that Italian corporates and banks now face a cost of funding which is 3.5 times more expensive than a couple of years ago.
It is therefore not surprising that corporate bond issuance has slowed down this year. Italian corporate bond issuance has exponentially increased since the global financial crisis and reached a peak last year, when, according to Bloomberg data, corporates bond issuance including financials came to €135 billion, while this year only €89bn has so far been issued.
As we have said many times, this bond bonanza was made possible by a combination of dovish European Central Bank policy, together with strong demand for higher-yielding securities in the euro area. A slowdown of bond issuance in 2018 means that Italian corporates are finally starting to feel the liquidity squeeze of higher funding costs and with ECB president Mario Draghi leaving his position next year, things could quickly go from bad to worse as support for southern European countries wanes.
Is it time to worry?
The fact that BTP yields are rising is mainly related to political uncertainties. Since the elections in May, headlines have scared investors about the possibility that the current Italian government, comprising a coalition of the Northern League and the Five Star Movement, may take a hard line towards the European Commission. And this is indeed what has happened. However, we have come to a juncture where politicians are pushed against a wall and if yields continue to rise, they will have a much smaller chance of delivering what they promised during the elections.
We therefore believe that we might approach the point at which Italian politicians may start to listen to the Commission’s requests and might be willing to compromise in order to find the right balance that may enable them to deliver part of their promises to the electorate while retaining the support of investors.
Obviously, such an agreement would see a good part of the Italian political arena screaming and kicking in protest, but people must accept that things cannot be different. This week we have already had news saying that Matteo Salvini, the Northern League’s leader, is open to negotiating with the EU and that the deficit number for next year is flexible.
Italian bond market: the opportunity many investors have been looking for
This may be the opportunity that investors have been waiting for. While the political situation of the Mediterranean country has been uncertain, credit spreads have been widening considerably compared to their European counterparts.Repricing among Italian corporates has been modest, but prices have been free-falling in the financial sector.
Subordinated bonds of the biggest banks have slipped almost 20 points since the beginning of the year. UniCredit 6.75% Perpetual (XS1107890847) started the year with a yield of 4% and this has more than doubled amid political uncertainty in Italy and volatility in Turkey. The same thing has happened for the second biggest bank in Italy: Intesa san Paolo. The subordinated bond of Intesa with 6.25% coupon Perpetual (XS1614415542) traded with a yield of 4.5% in January while it now offers 7.6%.
Leaving the subordinated bond world behind and looking at the less risky senior space, we can definitively say that prices have been correcting during the entire year. UniCredit senior unsecured bond paying 1% coupon and maturing in January 2023 (XS1754213947) is now trading around +120bps over the BTPs while at the beginning of the year it was issued with a mid-Swaps of +70bps.
It’s a different story in the corporate world: bond prices have undergone a small correction that means investors will not take home such a high yield, but negative headlines with the Telecom Italian corporate governance scandal and CMC Ravenna not paying the coupon on its 2023 bond, lead us to think that valuations are still high in the corporate sectors vs the financial one, hence our preference for the Italian banking space.
It is important to know that the Italian financial sector remains quite fragile due to high interest rates and large amounts of non-performing loans, hence it is important to look at bigger institutions and avoid those that are still struggling with a weak balance sheet such as Monte dei Paschi and other smaller Italian entities.