After a dramatic policy response to COVID-19, what's next for Italy's economy and bond markets?
Italy has been in focus recently for several reasons: the dramatic human impact of the early outbreak of COVID-19, the equally dramatic social and fiscal policy measures taken by its government in response to the economic impairment and, finally, the wild swings in its bond prices.
At a national level, the pandemic-induced lockdown has led to a significant drop in output but also in demand, similar to what has been experienced in other European economies. The latest data indicate that the Italian economy shrunk by almost 5% in the first quarter, with worse news to come in Q2. The Italian government currently estimates that its economy will contract around 8% this year, and sees a fiscal deficit of around 10%. By comparison, the IMF’s most recent forecast is somewhat more negative on growth but a bit more sanguine regarding the deficit; however, this assessment does not take into account Italy’s fiscal stimulus worth around 3% of GDP. Both sides agree that Italy’s debt-to-GDP level will rise by around 20 percentage points this year and approach 160%. While this well-known fiscal vulnerability is certainly reason for concern for market participants as well as rating agencies, it is worth highlighting that alternative measures that better reflect Italy’s ability to pay for debt service would indicate a lower level of concern, as long as the sovereign’s borrowing cost remains low (Exhibit 1).
Exhibit 1: Share of Italy’s Tax Revenue Spent on Interest
Source: European Commission/Haver. As of 06 May 20. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
At the EU level, Italy has played a vocal role in policy discussions, arguing vehemently for joint and several borrowing by European sovereigns, an effort the market dubbed “coronabonds”. Ultimately, the support package adopted by the European Council of Heads of State or Government did not include that type of financing source and it is unlikely that the recovery fund, currently still being designed, will include it. Yet, Italy could still be a major beneficiary of all elements of this package: the backstop for the existing short-term work scheme ("cassa integrazione”), lending to corporates by the European Investment Bank (EIB) and, politically somewhat more difficult, borrowing from the European Stability Mechanism (ESM). While accessing the ESM facility makes financial sense for Italy—after all, it is going to be much cheaper than borrowing in the market—the domestic political discussion largely evolves around the stigma associated with this type of lending and the perception of conditions associated with this loan. In reality, the conditionality is limited to spending the money on healthcare-related items—and paying back the loan such that the ESM can retain its AAA rating. Meanwhile, the recovery fund is also likely to include a grant element geared at particularly hard-hit regions in Europe, and it is highly likely that Italy would benefit from that.
The European Central Bank (ECB) is also currently working in two major areas to soften the fallout from the coronavirus and ensure monetary transmission in the eurozone is not hampered. The ECB has increased its asset purchases, including the creation of the €750 billion Pandemic Emergency Purchase Program (PEPP). Also, in an attempt to prevent a credit crunch, the ECB had cheapened existing long-term financing facilities, provided additional temporary ones and loosened the eligibility criteria for the collateral pool in repo operations to include “fallen angels”, i.e., debt of issuers that have lost their investment-grade rating after April 7, 2020. While the ECB has so far not increased the size of the PEPP or removed the investment-grade criterion for asset purchases (with the exception of Greece being made eligible for the PEPP but not the other asset purchase programs), these precedents could clearly become relevant if the rating agencies were to push Italy’s ratings closer to below-investment-grade.
To date, Standard & Poor’s and Moody’s have affirmed Italy’s current ratings and outlook at BBB (negative) and BBB- (stable), respectively. DBRS downgraded the trend to “negative” while leaving the rating at BBB (high), still three notches above high-yield territory. Whereas all these assessments took place at the pre-established dates, Fitch took off-cycle action and downgraded Italy to BBB- (with stable outlook) in late April. Fitch’s downgrade (and potential further rating actions) will likely heighten the concern of market participants that one of the largest sovereign debt issuers in the world would fall below investment-grade but it would also invite a policy reaction, including one from the ECB, along the lines mentioned above.
From an investment perspective, the yield spread between 10-year Italian bonds and German bunds of the same maturity has moved from 130 bps in mid-February to almost 280 bps a month later and currently stands at around 230 bps. We believe that ultimately the ECB will be willing to take more measures, including expanding the PEPP program in size but also enabling it to buy sovereign fallen angels. Indeed, the most recent monetary policy statement explicitly noted that “purchases will continue to be conducted in a flexible manner” and “until … [the Governing Council] judges that the coronavirus crisis phase is over”. This is a strong part of the argument supporting our favorable view of Italian bonds.
COVID-19 is the World Health Organization's official designation of the current novel coronavirus disease. The virus causing the novel coronavirus disease is known as SARSCoV-2.
A pandemic is the worldwide spread of a new disease.
The International Monetary Fund (IMF) is an international organization of various member countries, established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
Debt-to-GDP ratio is a measure of a country’s financial leverage, calculated as the country’s debt divided by the size of its economy.
The European Union (EU) is an economic and political union established in 1993 by members of the European Community. The EU now comprises 28 countries after its expansion to include numerous Central and Eastern European nations.
The European Stability Mechanism (ESM) is a permanent rescue funding program to succeed the temporary European Financial Stability Facility.
The European Investment Bank (EIB) is the European Union's nonprofit long-term lending institution established in 1958 under the Treaty of Rome.
Corona bonds are joint debt issued to member states of the EU. The funds would be common and would come from the European Investment Bank. This would be mutualised debt, taken collectively by all member states of the European Union.
The European Council is the Institution of the European Union (EU) that comprises the heads of state or government of the member states, along with the council's own president and the president of the Commission. Established as an informal summit in 1975, the council was formalized as an Institution in 2009 upon the entry into force of the Treaty of Lisbon.
AAA, AA, A and BBB are bond ratings considered Investment-grade by Standard & Poor’s Ratings Service,
The Pandemic Emergency Purchase Programme (PEPP) is a €750 billion ECB initiative that will be conducted until the end of 2020 and will include all the asset categories eligible under the existing asset purchase program (APP).
The European Central Bank (ECB) is the central bank for the European Union (EU).
The Governing Council of the European Central Bank is the main decision-making body of the European Central Bank (ECB) and has "sole responsibility" for formulating monetary policy in the Eurozone.
A fallen angel is a bond that was rated investment-grade but has since been downgraded to junk status due to the declining financial position of its issuer. The bond is downgraded by one or more of the big three rating services.
DBRS Morningstar is a global credit rating agency (CRA) founded in 1976 (originally known as Dominion Bond Rating Service in Toronto). DBRS was acquired by the global financial services firm Morningstar, Inc. in 2019 DBRS Morningstar is the fourth-largest credit rating agency with approximately between 2% and 3% of global market share.
High yield bonds, also called junk bonds, are bonds with below investment-grade ratings (BB, B, CCC for example) and are considered low credit quality and have a higher risk of default.
“Bunds” refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
Moody’s Investors Service, Fitch Ratings and Standard & Poor’s Ratings Service are nationally recognized statistical rating organizations (NRSROs) in the business of assigning ratings to bonds as they are issued.
A yield spread or credit spread is the difference in yield between two different types of fixed income securities with similar maturities.