Italian Debt Catches the ECB's Eye

When global stock and bond markets entered this year’s rough patch, we thought it was probably only a matter of time before investors returned to a long-running perceived negative: Italian debt.^[i] Any time eurozone bond yields rise, financial commentators we follow warn Italy’s debt woes will return, with soaring borrowing costs rendering the country unable to finance its debt—and resurrecting the eurozone debt crisis that occurred in 2011 – 2013. So it went this week as Italy’s 10-year yields jumped past 4.0%, leading to an emergency European Central Bank (ECB) meeting Wednesday to address the issue.^[ii] In what we consider typical eurocrat fashion, the bank announced a plan to have a plan but offered scant detail, leaving observers guessing.^[iii] Time will tell what exactly they roll out, but we don’t see much to suggest Italy needs the help.

Commentators we follow expressed some surprise last week when the ECB didn’t address Italian debt at its regularly scheduled meeting. Italian 10-year yields exceeded 3.0% at the time, and warnings about Italy’s debt were already percolating.^[iv] The bank’s silence, coupled with its discussions about raising its policy rate later this summer, seemingly sent sentiment sharply lower, triggering that jump over 4.0% for the first time since 2013, as the eurozone crisis wound down. (Exhibit 1) Hence, Wednesday’s emergency meeting.

Exhibit 1: Italian Yields in Context

Source: FactSet, as of 15/6/2022. Italy 10-year benchmark government bond yield, 14/6/2010 – 14/6/2022.

In its post-meeting statement, the ECB said it would work on an “anti-fragmentation instrument” to address divergence in eurozone member-states’ borrowing costs and “apply flexibility” when reinvesting the proceeds of maturing bonds in its portfolio. The first part appears quite nebulous, but commentators we follow are broadly guessing that it will be a new bond buying programme similar to the Outright Monetary Transactions (OMT) programme. Launched in late 2012 after then-ECB head Mario Draghi’s “whatever it takes” (to support the euro) speech during the heat of the eurozone crisis, OMT enabled the ECB to buy Italian and Spanish debt to reduce each country’s borrowing costs—a big fillip to sentiment at the time.^[v] We think the second part appears to be a pledge to alter the geographic breakdown of the ECB’s bond portfolio so that it can, say, invest the proceeds of maturing German and Dutch bonds into Italian Treasurys. That would theoretically enable it to proceed with its stated plans to reduce the size of its balance sheet whilst simultaneously supporting Italy—a rather clever move, in our view.

Sentiment over the ECB’s plan seems mixed, if reports from publications we follow are any indication. It didn’t cause the universal cheer Draghi’s “whatever it takes” speech did nearly a decade ago. Rather, many observers acknowledged the ECB’s apparent intent whilst bemoaning that the 150-word statement had no concrete, ready-to-go programmes. But markets seemed to appreciate it, with Italian yields easing a bit and Italian stocks rising nicely on the day.^[vi]

We read that move mostly as a relief rally rather than a sign that the ECB’s plans are a necessary change and fundamental good. As we have written before, rumours of Italy’s impending insolvency have long been greatly exaggerated, in our view. Whilst its total debt load is up, servicing that debt pile remains very affordable. As of Q1’s end, total interest payments represented just 12.4% of tax revenues, which is down from nearly 20% during the debt crisis—and down from well over 40% in the mid-1990s.^[vii] Rising rates could make affordability harder, but it likely won’t happen overnight. By 2021’s end, the average maturity of Italian debt outstanding was up to 7.11 years.^[viii] That suggests to us Italy has a lot of bandwidth to absorb higher rates, especially if it has managed to avoid default at times when debt service costs were far, far higher.

Some commentators we follow argue the pain will start arriving sooner if the ECB doesn’t act, citing the recent interest rate jump and the Italian Treasury’s seemingly big financing needs. This year, about €369.5 billion (£315.9 billion) worth of Italian bonds are maturing, including about €227.8 billion (£194.8 billion) in standard medium- and long-term bonds, known as BTPs.^[ix] Based on the amount raised year to date, it does look like the Treasury is back-end loading its refinancing: Through Wednesday, the Treasury has met less than half its BTP financing needs for the full year, with only €92.3 billion (£78.9 billion) sold.^[x] Things perhaps look especially bad on the 10-year front, with nearly €60 billion (£51.3 billion) maturing this year and only €17.5 billion (£15 billion) sold thus far.^[xi] But we think there is more than meets the eye here: Even at today’s higher rates, Italy is refinancing much of its maturing debt at a discount. Commentators were astir when the auction of 10-year bonds two weeks ago carried a 3.1% gross yield, but it replaced a bond with a 5.0% coupon.^[xii] Even if the 10-year stayed above 4.0% for the rest of this year, Italy would still be replacing maturing 10-year BTPs at lower rates.^[xiii] Consider: 10 years ago was 2012, the very height of the eurozone sovereign debt crisis, with rates noticeably higher than today’s as a result.^[xiv] Some of the shorter-dated BTPs issued this year even fetched lower yields than the issues they replaced.^[xv]

In short, even if the ECB did nothing, we don’t see much evidence Italy would be on the brink of a crisis. Based on the analysis shown above, rising yields thus far aren’t translating to skyrocketing debt service costs. Bond auctions are routinely oversubscribed.^[xvi] Then, too, Italy’s rising yields are part of a global trend, and for all the handwringing, they are only about 60 basis points above US yields—in our view, the true risk-free benchmark, given money would likely flow to the dollar in the event of a debt crisis repeat, not another euro country like Germany.[xvii] If Italian debt were really so troubled, we think it would likely fetch a much larger premium, as it did in 2011 and 2012. (Exhibit 2)

Exhibit 2: Rate Spreads Aren’t at Crisis Levels

Source: FactSet, as of 15/6/2022. Italy 10-year benchmark government bond yield minus US 10-year constant maturity Treasury yield, 14/6/2010 – 14/6/2022.

From our vantage point, we think Italy looks like a prime opportunity for uncertainty to fall, likely boosting sentiment higher. To the extent the ECB helps accelerate that process, we think markets will probably welcome it. But even if policymakers don’t go big, we think markets are likely to gradually realise that Italy isn’t anywhere close to being unable to service its debt, likely bringing stocks globally some relief.