Irresistible Italian BTPs. It is the opinion of BG Saxo, according to which i Italian government bonds offer attractive buy-to-hold opportunities (buy to hold over the long term) compared to other European government bonds. Why? The reasons are different: on the one hand, they provide a tool to avoid negative interest rates on deposits to savers, since they pay a positive return starting from four years; on the other hand, the risk remuneration they offer is among the most compelling in the European bond market for long-term investors. Index-linked government bonds would also offer the cheapest inflation protection found in the euro area.
BG Saxo’s analysis begins with identifying the factors that are driving the losses in Italian government bonds, so as to dismantle them one by one. There would be three elements, in particular:
1. The market fears that the European Central Bank could reduce purchases under the Pandemic Emergency Purchase Program (PEPP), of which Italy is a major beneficiary.
News that the Hungarian central bank may raise interest rates in June before cutting back on purchases as part of quantitative easing caused a large correction in European sovereigns. The news comes at a time when other central banks have also begun to tighten their countries’ financial conditions in light of mounting inflationary pressures. Thus, investors fear that the ECB will follow this trend and start reducing purchases under the PEPP starting next month, when the central bank will review the program. This possibility has prompted investors to sell Italian BTPs, given that the country is one of the largest beneficiaries of purchases under the PEPP program. However, BG Saxo believes these fears are unfounded and that BTPs will continue to be supported by the ECB’s accommodative monetary policies. Why?
Here is the answer. One of the main reasons why investors believe the ECB may begin to tighten financial conditions in the euro area is that German real rates remain stable while nominal Bund yields continue to rise. In February, when the ECB announced that it would increase purchases under the PEPP program, nominal Bund yields were rising along with real yields, tightening financial conditions. However, now that German real yields are stable, real yields from other European countries are rising, exacerbating economic conditions in specific geographies. “Therefore – conclude by BG Saxo – we believe that the ECB will have to continue to support financing conditions through a stable pace or even by increasing purchases of bonds under the PEPP program to support economic recovery in these countries ”.
Investors are focused on Italy due to the bad reputation the country earned during the European sovereign crisis. However, investors turn a blind eye to France, whose public debt surpassed that of Italy in March last year. Not only that, but French private debt has also increased exponentially, putting the country’s economy in a delicate situation. While French government bond yields remain close to zero, 10-year French OAT yields rose 65 bps from December lows to two-year highs. By comparison, yields on Italian 10-year BTPs have risen to roughly the same level since their February lows. However, 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 also a more significant beneficiary of ECB bond purchases under the PEPP program than Italy, which makes it even more exposed to possible tapering risk.
2. Political uncertainty remains and will continue to be a recurring problem
The second element weighing on Italian government bonds concerns the uncertainty within the political scene, which has always been a problem. Currently, the main problem is that the current government is a coalition of many different parties, including the PD (Democratic Party), the Movimento 5 Stelle, Forza Italia, the Northern League and other smaller center and center-left parties. Mario Draghi must implement key reforms required by the European Union within this very fragile balance. However, Matteo Salvini, head of the Northern League, recently said that the current government will not be able to implement these reforms. His party is trying to push Draghi to the presidency of the country in early 2022, forcing Italy into early elections. Such a scenario can be worrying because Salvini’s Lega Nord party leads the recent polls (21%). Polls that also see Fratelli d’Italia at the top, a far-right national conservative party led by Giorgia Meloni, which is gaining consensus by the day. This opens up the possibility that Eurosceptics lead the next Italian government, which would make the relationship with the EU problematic. According to BG Saxo, however, the country’s political background remains solid as long as Draghi is prime minister. “Even if a conservative government poses a threat, we believe it is too early to evaluate it in the BTPs, as things can change quickly,” he points out in his analysis.
3. The economy is gradually opening up
With the reopening of the economy and the lifting of restrictions, a resumption of European economic growth is expected. Higher growth and sustained inflation levels mean that the central bank will have to start tapering and raise interest rates gradually. This is why news of a successful Covid-19 vaccination campaign and the reopening of the economy drives interest rates up. In this context, Italian BTPs are becoming more and more desirable, according to Bg Saxo, precisely because they offer ever higher yields, they become more interesting than their competitors for the following reasons:
– Smaller investors will try to use BTPs for deposit excess liquidity to avoid negative interest rates on deposits. Italy is the only European country that offers a positive return from four years upwards. To ensure a positive return in Portugal and Spain, you have to go beyond 6 years. French OATs pay a positive return from eight years on.
– For long-term investors it will be it is difficult to find better risk remuneration in the European bond space. Investors with long-term investment horizons, such as pension funds and insurance, will find that Italy currently offers the highest yield in the European region. Italian BTPs even offer a higher yield than Greek government bonds, which are classified as junk. Ten-year BTPs pay 1.1% at the time of analysis, while 30 and 50-year bonds pay a solid 2% and 2.5% yield. By comparison, according to Bloomberg Barclays indices, high yield EUR corporate bonds offer an average yield of 2.5% over three and a half years of term. Investment-grade EUR corporate bonds offer an average yield of 0.38% for an average term of six years.
– Italian inflation linkers are less expensive than their counterparts. As inflationary pressures resurface, investors are looking for protection. Unfortunately, the incredibly expensive European inflation linkers. German linkers provide a negative return of almost -2%. Against this backdrop, Italian index-linked government bonds shine as they provide a slightly negative yield of -0.2%, allowing investors to gain low-cost inflation protection compared to other EUR linkers.
“When looking at Italian BTPs, it is essential to understand that yields are destined to rise just like all other European sovereigns – continues the sim – This means that all sovereigns in the euro zone, including Italian government bonds, will lose value. Therefore, it is necessary to look at BTPs as a buy-to-hold opportunity ”.
The risk of rotation from European government bonds towards US Treasuries remains worrying. While European yields have increased, the pick up that countries like Greece offer is marginal compared to the yield provided by euro-hedged US Treasuries, while leading to obvious liquidity and credit problems. If we look at Portugal and Spain, the yield offered by euro-hedged US Treasuries becomes even more attractive. “In this context – writes BG Saxo – we believe that the Italian BTPs are too high compared to their analogues. The higher their yield, the less exposed they will be to the risk of rotation ”. In short, “we welcome the rise in yields in Italy, but we fear that the rise in yields in the rest of the euro zone will be much more brutal”, conclude from the sim.