Analysis-Italy’s bonds set for plain sailing until possible summer storms

By Sara Rossi

MILAN (Reuters) – The first half of next year will offer favourable conditions for Italian government bonds after a stellar 2023, analysts say, but problems may surface from June onwards connected with politics and future moves by the European Central Bank.

The sustainability of Italy’s 2.4 trillion euro ($2.6 trillion) public debt, one of the biggest government bond markets in the world, has long been seen as a potential weak link for the stability of the 20-nation currency bloc.

Those worries have been exacerbated by a string of ECB rate hikes since last year to fight inflation that have taken euro zone interest rates to record highs.

But Italian bonds have drawn strong demand through 2023 thanks to appealing returns, and are ending the year on a high note after Rome confounded expectations by weathering a series of potentially dangerous reviews by credit ratings agencies.

The closely-watched gap between the yields on Italian 10-year BTPs and less risky German Bunds fell below 165 basis points (1.65 percentage points) on Tuesday, the lowest level since late August.

Nonetheless it remains considerably higher than the spread versus Germany of any other euro zone country, a sign markets remain wary of Italy’s stubbornly high debt – equal to about 140% of national output.

“In 2024 BTP spreads could widen just a little but not enough to justify an ‘underweight’ position,” said Bruno Rovelli, chief investment strategist at BlackRock (NYSE:) in Italy.

The world’s largest asset manager is “neutral” on BTPs, the same stance as it has on other European bonds.

Gregorio De Felice, chief economist at Intesa Sanpaolo (OTC:), was more upbeat.

He predicted a trouble-free year for Italian bonds, bolstered by the stability of Giorgia Meloni’s 14-month-old government, and said the BTP-Bund spread could decline to 120-130 basis points by the end of the year.

The narrowing of Italian spreads over the last few months confounded the expectations of analysts who had forecast the government’s deficit-hiking 2024 budget, presented in October, could trigger negative responses from the ratings agencies.

Instead, S&P Global, DBRS and Fitch all left Italy’s position unchanged. Moody’s (NYSE:), which rates Rome just one notch above junk, upgraded its outlook to stable from negative.

“With Italy out of rating agencies’ crosshairs, foreign buyers could further increase their Italian debt holdings in 2024,” said Luca Cazzulani, head of strategy research at UniCredit.

Despite a revival of interest last year, foreign holdings of Rome’s debt are still about 100 billion euros lower compared with the pre-pandemic level of 2019.

CHALLENGES FROM MID-YEAR

The picture could become less bright from the middle of the year, analysts warned, with risks posed by the phase-out of ECB purchases of government bonds, new EU budget rules, and European parliament elections.

“The crunch point for Italy could come after the summer, when the government might have to make some difficult choices on the 2025 budget,” said Fabio Balboni, senior economist at HSBC.

Last week’s announcement by the ECB that from June 30 it will end the full reinvestment of paper bought under its Pandemic Emergency Purchase Programme (PEPP) could have a significant impact on Italy, the scheme’s main beneficiary.

“The early end to PEPP reinvestment could increase the risks for the BTP spread,” Balboni said.

The June 6-9 European parliament elections may also hurt Italian debt if they throw up a strong result for parties less committed to integration, leaving fiscally weaker members like Italy in a more vulnerable position, analysts said.

The outcome of EU negotiations to revamp the bloc’s fiscal rules, which have been suspended since 2020 due to the COVID-19 pandemic, should also be clear by the summer.

If the new Stability and Growth Pact requires steep debt reduction Italy is more likely to fail to meet its terms, analysts said.

This would increase friction with Brussels and the risk that the ECB would refuse to support Rome through its new Transmission Protection Instrument (TPI) which is only available to countries that are compliant with the EU’s fiscal framework.

Italy will need to find buyers for a net debt supply of around 135 billion euros in 2024, some 20 billion more than this year, said Unicredit (BIT:)’s Cazzulani.

The task is made more challenging as the ECB, a major holder of Italian bonds, continues to reduce its balance sheet.

Small domestic savers will be an important buyer of Rome’s debt next year and foreign investors could also potentially be net subscribers, said Sylvain De Bus, deputy head of global bonds at international asset management firm Candriam.

This year the Treasury made a major effort to tap Italian retail investors, who analysts expect will continue to play a significant but somewhat lesser role in 2024.

Small savers’ holdings of Italian government bonds rose to 12.6% of the total in September from 7.5% a year earlier, according to the latest Bank of Italy data.

Foreign holdings declined to 27.1% from 28.2%, well below a level of 34.6% in March 2020.

($1 = 0.9114 euros)

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