ITALY Government Debt to GDP
Italy Government Debt to GDP ratio (Figure 6) is 119%, which already higher than that of Greece, Portugal and Ireland, and has been in on significant increase since 2009. Italy’s borrowing costs remained elevated despite the European Central Bank buying its bonds in 2011.
- Political condition of Italy
During this year, Italy has changed into a country whose atrophied and self-serving political system threatens to destroy the euro zone and is hampering Italy’s image and growth. The fragility of Italy’s governing coalition, the chain of events that directly affect the Prime Minister Silvio Berlusconi, and his persistent inability to take painful but necessary decisions has contributed to a surge in Italian government bond yields.
With the markets again registering alarm—the difference in yields between Italian and German benchmark bonds widened sharply—the Prime Minister came out with Italy’s second emergency budget2 to calm down3 the bond market. Also Italy, euro area’s third-largest economy and the world’s third-biggest issuer of government bonds, might get into the debt crisis.
Will the fearfulness of Eurozone crisis 2011 turn into another panic like 2008? Here the parallels with the credit crisis three years ago become ominously inexact. Analyst believes the root of current problem for Italy which is affecting bonds started with the credit crisis three years back.
The other side of coin is that while Italy’s economy fell deeper into recession in 2009 and is recovering more slowly than its European peers4, analysts also believes that market reaction has been overdone as:
- Biggest fiscal adjustment made by any leading country in decades in 2011
- Set to improve the fiscal primary balance to a surplus of 5.7 per cent of GDP in four years.
- ECB is Italy’s central bank and, as already demonstrated, it stands behind the Italian sovereign.
- Trends
- Past trends ( last 3 years)
- Italy's Government Bond Yield for 10 Year Notes rallied 176 basis points during the last 12 months
Figure 7 Figure 8
- Italy's Government Bond Yield for 10 Year Notes averaged 5.94 %
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Current Trends
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Current rating and recent downgrades
Current Sovereign ratings [for Italy (Figure 9)] are critical for investors as more governments with greater default risk borrow in international bond markets.
Figure 9
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Further Downgrades
All the three rating agencies have a negative outlook on the debt, meaning further downgrades are possible adding to the pressure on Italy’s banks, heavily exposed to domestic sovereign debt.
Losing the rating or being downgraded further can have a fatal effect on Italy’s ability to borrow money on the markets and will lead to major change in the yield of the bonds.
- Default and a haircut
As per analysts the current levels are not yet imminently threatening, but Italian bond spreads are within 150bp of levels of LCH.Clearnet 6 activity (Figure 10). So far Italy have avoided the 30% margin increase applied to other troubled sovereigns in the past plus to see greater ECB support if spreads to Triple A benchmarks reach critical levels.
Source: ECB Figure 10
Chances of Default:
Moody’s said the risk of default by Italy remained “remote”.
Italy’s gross debt-to-GDP ratio is large, at 120%, and the country has a chronic growth problem, but it is not insolvent. Its primary balance (i e, excluding interest payments) is in surplus and the average maturity of its debt is a reasonable seven years.
- Possible Future Trends
- Germany Treasure bonds are the safest bet in coming months.
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Analysts do not expect more than meagre growth (Figure 11) over the next two years
Figure 11
- Risks to the Italian government's fiscal targets( 2011-2014)
- Political issues could contribute to delayed policy responses to new macroeconomic challenges and result in significant fiscal slippages
Due to above risks Italy's net general government debt could increase further and could lead to even further lowering of the long- and short-term ratings
- Impact of these Trends
- Italy forced to pay higher rates
Italy was forced to pay sharply higher rates (Table1) in different bond issues (in last 4 months) as it came under fire from investors (due to rating agencies warnings).
Table 1
Figure 12 Figure 13
Figure 14
The spread between Italy’s 10-year bonds and Germany's - which are considered the safest in Europe - hit a new record (Figure 12-14); Italy’s highest since the creation of the euro.
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ECB buying Italian bonds
Figure 15
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Selling Pressure
While borrowing costs for Italy have declined from euro-era records with the ECB’s help, Italy is in pressure now to sell about 55 billion Euros of bonds this year. Uncertainty still remains as Italian bonds made a 4.1 percent loss and the nation’s borrowing costs jumped at subsequent auctions amid speculation of a Greek default.
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Outstanding Debt
Italy had 1.6 trillion Euros of outstanding debt as of Aug. 31making it Europe’s biggest national bond market.
Figure 16
It has to pay 88 billion euros to redeem bonds and bills maturing in the second half of 2011 and 291 billion euros in 2012.
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Multiple equilibra
It is an unfortunate situation (Figure 17) for Italian bonds due to the recent trends.
Figure 17
In normal times (upper part of the Figure 18), demand for Italian bonds is downward sloping. As prices fall (yields rise), demand rises. But at a certain point, higher yields call into question Italy’s solvency, and demand actually falls. In this zone of vulnerability, the demand curve is upward sloping.
Figure 18
Investor’s perspective/Investment considerations
Investor opinion is more divided about Italy than any other peripheral eurozone country. Key points Investors should consider before investing in Italian Treasury bonds:
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Risks in Government bonds
Inflation risk: If inflation rises, the value of the investment may decline
Interest rate risk: Italian Treasury bond prices will have an inverse relationship to interest rates. When one rises, the other falls (Malkiel’s Theorem One). If Investor has to sell an Italian Treasury before it matures, the price Investor can fetch will be based on the interest rate environment at the time of the sale.
Opportunity Cost: The yields on Italian bond will be far short of the yields on corporate bonds costing the Investor the opportunity6 for money.
- Credibility of the Italian Government, Credit Ratings and Indexes
Important assessment factor is current ratings for Italy(Figure 19)and other countries issued by Moody’s, Standard & Poor’s and Fitch can tell Investor (Section 4.2.1) how much risk7 is associated with the Italian Treasury bond.
Figure 19
Figure 20
Investors may choose to use above index as a benchmark to measure the performance of the Italian bonds.
- Yield
The yield to maturity of a bond lets Investor measure the actual return on investment. The yield on Italy’s 10-year bond climbed seven basis points to 5.52 percent in London on 7th October. The rate increased as much as 14 basis points, the most since Sept. 20. Volatility of yield (Figure 21) is a critical factor.
Figure 21
Source: Bloomberg Figure 22
Investors need to look at precise yield to maturity of Treasury bond not only the current yield and also yield of other countries (Figure 22)
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Euro vs Dollar Currency relationships
US dollar investments are worth less against European Euros and pounds sterling because the exchange rate has changed significantly between the dollar and European currencies.
- Recommendation
Summarising sections 2 to 6(Representing the trends for last few years), SWOT analysis is done (Figure 23) to aid in coming up with the recommendation about investment decision making in Italian Treasury bonds.
Figure 23
For the Recommendation, the strength and opportunities from SWOT were evaluated against the weaknesses and threats of Investing in Italian treasury bonds. The recommendation based on the SWOT evaluation is that it is not the right time to invest in Italian Sovereign bonds as in the long term, the scenario is pretty gloomy.
Some additional points (from this Paper’s content itself) supporting the recommendation are:
- In comparison to Corporate bonds, government bonds were risk free but in the current scenario there is a risk of default of Italian Govt like Greece
- The Italian economy's weakening growth prospects is likely to hamper any chances of economic recovery affecting the bonds directly
- Italian Bond yield volatility specially in comparison to other countries
- With very high debt-to-GDP ratio, it is less likely for Italy to pay its debt back, and may be more likely to default. Italian debt has turned into becoming a risk asset as there’s no (nominal) GDP growth in Italy. Huge Italian debt will lead to Long term unavailability of funds
- Italy’s borrowing costs remained elevated despite the European Central Bank buying its bonds recently
- Conclusions
Based on the recommendation above and the impacts of the trends from last 3 years presented in this Paper, I conclude that in the current scenario investing in Italian Treasury bonds is a risky Investment and not to be undertaken specially for fiscally conservative investors.
- APPENDIX I.
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A sovereign default is a failure by the government of a sovereign state to pay back its debt in full. If potential lenders or bond purchasers begin to suspect that a government may fail to pay back its debt, they may demand a high interest rate in compensation for the risk of default. A dramatic rise in the interest rate faced by a government due to fear that it will fail to honour its debt is sometimes called a sovereign debt crisis. ()
- When the Austerity budget was passed in September, the government said it would take €45.5 billion off the projected budget deficit and balance the budget by the end of 2013. The Prime Minister, Silvio Berlusconi, then threw out €7 billion worth of spending cuts and tax rises. As per Analyst this is likely to prove a temporary reprieve for Italy’s Bond market.
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LCH.Clearnet (previously known as the London Clearing House and the Paris based Clearnet) is a British independent clearing house, serving major international exchanges and platforms, as well as a range of markets. LCH.Clearnet clears approximately 50% of the $348 trillion global interest rate swap market, and is the second largest clearer of bonds and repos in the world, providing services across 13 government markets. LCH.Clearnet added up to 5% to the level of collateral required for Italian bonds with maturities of over 10-years as their Framework considers a spread for 10-year bonds of 450bp over the 10-year Triple A benchmark to be indicative of significant additional sovereign credit risk and would apply an additional haircut at this level of 15%.
- Opportunity cost refers to the difference between what Investor earns on a Government bonds investment and what Investor could have earned on investing somewhere else.
- Investor to understand that the high interest rate offered recently by Italy with a lower credit rating is in exchange for risk of a higher likelihood of default.
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According to its treasury’s
- Multiple Equilibra: Only once Italian bond prices fall into distressed territory, presumably at much lower deficits and levels of GDP, does the curve resume its normal shape.
- Source wikipedia
- REFERENCES
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Brealey R.A., Myers S.C, Allen, F 10th Edition, Principles of Corporate Finance, Mc-Graw-Hill Companies, New York.
- Understanding wall street fifth Edition by Jeffrey and Lucien
- Valuation : valuing and measuring the companies: Tim Koller
- Malkiel’s theorem from the Book Portfolio Construction Management, and Protection (with Stock-Trak Coupon) By Robert A. Strong (Page 350)
- No Fear Finance by Guy Fraser-Sampson 2011
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Web sites( Last accessed 15th October)
- http://www.ft.com/cms/s/0/8a071b2e-e391-11e0-8f47-00144feabdc0.html#axzz1ZkVVMEzM
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- Reference : Standard & Poors | RatingsDirect on the Global Credit Portal | September 19, 2011
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- Investinginbonds.com
- Quote reference : Reference : Bloomberg Business week Page 48, sept 12-sept18, 2011
Trends in Italian Sovereign Bonds Page
