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Follow the money: why the junk-rating threat matters for Italy

By Dhara Ranasinghe

LONDON, May 6 (Reuters) Italy’s place in the ranks of investment-grade sovereigns could become increasingly precarious over the coming year, putting at risk bond investments of over a trillion euros and creating immense pressure on the European Central Bank to keep Italian borrowing costs in check.

Nerves are on edge ahead of a May 8 review by Moody’s. The ratings agency is unlikely to cut Italy off its perch on the lowest rung of the investment-grade ladder, but it could move it a step closer to junk by downgrading the rating outlook to negative.

Of the three main agencies, Fitch and Moody’s rate Italy BBB- and Baa3 respectively. S&P is a notch higher at BBB.

At those levels, the threat is at least a year away. And a fall into junk is also unlikely to deprive Italy of the ECB’s bond-buying backstop — after the recent inclusion of junk-rated Greece into emergency ECB stimulus, a similar waiver will almost certainly be extended to Italy.

Instead, what’s at stake is a flight of foreign investment out of Italy’s 2.4 trillion-euro government bond market, where non-residents hold just over a fifth of outstanding debt.

Aside from pension and insurance funds, which only buy top-grade bonds, there are passive, or index-tracking managers who are forced to sell when a credit loses its investment grade, because the indexes they follow will eject the government or company in question.

Some indexes, including Markit’s iBoxx euro benchmark and the Bloomberg/Barclays euro aggregate, use the average ratings of Moody’s, S&P and Fitch.

A cut to junk by one of the three major agencies matters primarily because of index exclusion factor, said Ross Hutchison, a rates fund manager at Aberdeen Standard Investments.

“Although the ECB’s decision to lower the rating requirement for Greece in the PEPP (Pandemic Emergency Purchase Programme)will mitigate the damage of a downgrade, the forced disinvestment flows from private investors would likely dominate short term,” he said.

Italy has around a 23% weighting in the iBoxx euro benchmark index, valued at over 5.5 trillion euros. Its share of the index is roughly 1.38 trillion euros, the second biggest after France.

If relegated to junk, Italian debt would be ejected from that benchmark and join the iBoxx EUR Sovereigns High Yield index, with a considerably smaller value of around 57 billion euros. This index currently contains Greek and Cypriot bonds.

Italy also has a 15% weight in the FTSE Euro Broad Investment-Grade Bond Index, for which either a BBB- rating by S&P or Baa3 by Moody’s is the minimum requirement.

The 24 trillion-euro FTSE World Government Bond Index (WGBI), containing sovereign debt from over 20 countries, assigns Italy a roughly 7% share as of the end of March. Analysts estimate roughly one $1 trillion of passive money tracks the WGBI.

FTSE Russell does not have a high-yield government bond index.

Finally, there is the Bloomberg/Barclays euro aggregate bond index with a market value of over 12 trillion euros ($13.25 trillion). This provider did not return an email seeking information about its constituents or tracking funds.

The pain point for Italy is a debt ratio that could end the year at 180%, versus around 130% now, due to economic recession and pandemic-fighting expenditure.

Mauro Vittorangeli, CIO for conviction fixed income at Allianz Global Investors, said Italy’s ejection from the indexes would be a “big mover” unlike when Greece and Portugal lost access in the past.

“I don’t think it is a short-term risk, but in the intermediate term Italy will remain under pressure,” he said.

One mitigating factor is that the prospect of ECB support would likely cushion the blow from investors who bail out when they sense an impending downgrade to junk. Second, Italian yields and spreads over euro zone peers may already be consistent with a sub-investment grade rating.

“We have calculated it to be consistent with a BB rating – 10-year BTP yields, after all, are only 30 bps lower than 10- year Greek government bond yields,” said Richard McGuire, head of rates strategy at Rabobank.

Italy’s 10-year bond yield is at around 1.88% IT10YT=RR; the Greek equivalent is at 2.17% GR10YT=RR.

Rising risks for Italy's position in bond indexes pnghttps://tmsnrt.rs/2VOb2MU

Italy’s debt to GDP set to jump in face of coronavirus crisis IMAGEhttps://tmsnrt.rs/3aLOkJC

(Reporting by Dhara Ranasinghe; additional reporting and charts by Ritvik Carvalho; editing by Sujata Rao and Larry King)

((Dhara.Ranasinghe@thomsonreuters.com; +442075422684;))

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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