By Zac Tate, Hottinger Investment Management
Last week, the Italian treasury issued €3bn in 50-year bonds. According to Reuters, the issue drew over €17bn of bids, 80% of which were from foreign investors, with Germany the single biggest source of capital. The final yield came out at 2.877%.
International interest in Italian bonds comes in the context of a general scramble for government bonds amid fears of a widespread global slowdown. In the belief that interest rates are broadly coming down and the ECB will stand behind Italy’s public debt, investors appear to have parked their concerns about Italy’s political situation.
Last May, Italian 2-year yields spiked above 2.7% and 10-year yields rose to over 3.5% in the following months as the Italian government threatened to break the EU’s budget rules in order to increase public spending. Even though Italy’s de-facto leader Matteo Salvini and others in his administration have since toned down their rhetoric, it is hard to make the case that Italian public debt is now a safe asset. Investors may come to regret piling into global government bonds generally and Italian bonds specifically.
Who can blame the Italian debt management office for capitalising on the great rally in global bonds? Academic research by Martin Ellison and Andrew Scott finds that issuing long-dated bonds actually costs most governments more over the long-term compared with rolling over shorter-dated bonds as they fall due. This is because the premium that investors charge for duration risk, combined with the fact that we live in an environment in which central banks have anchored inflation at low and stable levels, amounts to a subsidy from the government to investors. Italy, however, is a different case and we should ask why the country might be interested in issuing more longer-duration bonds.
Issuing large amounts of very long-dated debt only really makes sense if you cannot rely on the market to offer you stable short-term rates, if you are planning to announce a big spending programme and do not want refinancing costs on your existing debts to rise, or – more perversely – if you are intending to generate a bout of surprise inflation in the future to reduce the real value of the debt you have issued. This last reason does not really apply to Italy because it does not have control over its money supply and – as a member of the eurozone – it has only a limited ability to generate inflation in its own country independent of the European Central Bank.
Nevertheless, this lack of independence makes the situation for Italy quite interesting. Italy currently carries a debt-to-GDP ratio of over 130%. That ratio is high not because the Italian government has been feckless in recent years; in fact, since the early 1990s, in every year except 2009, Italy has run a primary budget surplus. Italy’s problems lie in the fact that it built up huge debts in the 1960s and 70s as it expanded its welfare state; since then, it has simply rolled those debts over rather than paying them back. Italy has had difficulty repaying legacy borrowing as economic growth and inflation have struggled to exceed the rate of interest that investors charge on bonds. Even today, Italy’s economy is still smaller than it was in 2008 and not much larger than it was in 2001. The German economy, by contrast, is over 50% bigger than it was at the turn of the millennium.
With Italian growth anaemic and the ECB conducting a monetary policy that is too deflationary for the country, Italy’s indebtedness is a problem for markets, which tend to react sensitively to developments in Italy’s economy and politics, quickly repricing Italian debt. It is also problematic for the Italian government, as high legacy debts constrain its ability to vary fiscal policy, either according to movements in the economic cycle or according to structural requirements such as the need to invest in infrastructure and education.
It therefore makes sense for the Italian government to reduce its reliance on short-term debt as it cannot know in advance whether maturing bonds will come due in a period in which the markets have very little confidence in the Italian economy and the Italian government wants to spend more money – such as during the euro crisis. Issuing longer-dated bonds can therefore reduce repricing risk and thus default risk.
Even still, it is costly. The 2.8% yield on the 50-year bonds is a little above the peak of the spike in 2-year yields, which occurred after the announcement of the Italian government’s intentions rapidly to increase spending in May 2018. So, the second and third justifications for issuing long-dated debt also still stand: future spending and higher inflation. If the Italian government is secretly preparing a large fiscal stimulus or thinks that an Italy-friendly ECB will generate inflation that exceeds the spread between 50-year and 2-year bonds, then the Italian government will benefit from issuing long-dated bonds. This is because, in the first instance, markets will have less ability to punish Italy for pushing its debt level higher by increasing interest rates; and in the second instance, the eroding effect of higher inflation will help bring down Italy’s debt burden by forcing real-terms losses on long-term bondholders. If any rise in public spending pushes debt beyond sustainable levels, then long-term bondholders could face capital losses as the risk of default and haircuts rises.
It is too much to infer intentions from relatively small issues of long-dated debt, but if this trend continues as other existing bonds mature in the coming months and years, alarm bells ought to start ringing among the foreign investors who are piling into Italian debt today in the search for ‘safe’ assets. The expectation that a dearth of safer German bunds will force the ECB to hold more Italian bonds in any future round of quantitative easing is not the strongest insurance against any possible long-term erosion in the real value of Italian sovereign debt.
The narrowing of the 30yr-2yr spread appears to suggest that investors are more comfortable in Italian bonds that mature well into the future, or at least after the passing of the current, populist administration. They appear to be less concerned about long-term Italian inflation and debt dynamics than they are about the risk of a sudden re-emergence of a budget crisis in Italy. With 10-year bonds now yielding less than they did before the Italian government took on the EU over public spending whilst 2-year yields are still above their pre-event levels, one could argue that shorter dated Italian debt continues to carry a small risk premium.
We think there is also a general possibility that this global bond rally is a bit overdone. Investors are scarred by the financial crisis and have seized on the link between the ongoing trade tensions and slowing global manufacturing as foreboding a global recession à la 2008. If we learn that at worst, any coming recession will be shallow and that at best fundamentals are still actually okay, then all those who are piling into bonds today could quickly get burned. This applies to Italy too, but the more pressing concern is an escalating political disaster that pits Italy against the EU in a future crisis over its budget. In that situation, investors who are scooping up 50-year Italian debt at under 3% may come to regret it.