Yeah, so over the weekend, in a kind of rambling piece penned while attempting to block out the noise from a literal outdoor aerobics class that convened around me unexpectedly (I sometimes write from a picnic table at a pavilion down by a local pier and unbeknownst to me, one local fitness instructor has decided that this tourist season, she’s going to commandeer that pavilion for her classes, presumably because it has a nice ocean view), I talked about the Italian “problem” in the context of ECB CSPP.
You can read that linked post for yourself, so I won’t rehash the whole thing, but one of the points I made was that given the representation of Italian credits in € IG and € HY, and given the fact that ECB corporate bond purchases have served to prevent the market from pricing in credit risk, it seems at least possible that spreads on Italian credit will reprice wider on the back of perceived political risk. If that coincides with expectations of CSPP coming to a close in September, it could serve as a kind of double whammy for € credit (i.e., the Italian components sell off, exacerbating the effect of a fading technical tailwind from CSPP).
In a companion post to the one linked above, I highlighted a chart from a BofAML note by Barnaby Martin out earlier this year. Here’s that chart and some of the accompanying color:
And have a look at this:
I’m not sure that’s a great setup. Is it realistic to assume that much Italian IG credit will continue to trade inside of BTPs in the event the latter continue to selloff and widen vis-à-vis bunds?
BTPs of course sold off heavily earlier this week as jitters about the possible introduction of a parallel currency collided with more generalized concerns about Italy’s fiscal situation under a populist government, and while there was some dip-buying on Tuesday, the selloff resumed on Wednesday.
Ultimately, this is where things stand on the risk premium over safe haven bunds:
How “fair” is that? Well, that’s obviously a subjective judgment, but if you ask Goldman, they’d tell you the following:
BTPs incorporate a political premium worth around 40-50bp. Using last night’s close of 185bp… BTPs trade close to 2-standard deviations above ‘fair’. Last week, with spreads at 150-160bp, we suggested that the 175-200bp range was likely to be seen in light of the heightened uncertainty around the formation of the government and its composition. If sustained, spread levels above 200bp would mark a new phase of the turmoil.
Tactically, we would be neutral on 10-year BTPs with spreads in the 175-200bp area. If the anti-Euro rhetoric subsides and the Ministry of Finance is offered to an individual with a moderate stance and relevant background, which is our base case, spreads could come back to the 150-160bp range, as levered short positions are closed. Should, instead, the profile of the Cabinet profile and statements by its members continue to send conflicting signals around Italy’s Euro participation, we could see the 10-year BTP-Bund spread reaching 250bp, pushing the yield on 10-year BTPs towards 3%. Probability-weighting these two outcomes, we come out as tactically neutral at this stage.
Obviously, the evolution of this depends in no small part on the messaging from the ECB which, on a net basis, has been the only buyer of Italian sovereign debt over the last year.
But here’s the really interesting thing. Look back up at that chart which shows the percentage of Italian credits yielding less than similar maturity Italian govies. So again, that was from earlier this year. Well, the above-mentioned Barnaby Martin has updated that chart and as he writes in a new note, “we’ve been struck by the extreme relative value gap that’s opened up between Italian credit and Italian sovereign debt during the last week [as] Italian credit spreads have held up incredibly well vis-à-vis BTPs, amid the volatility.”
In fact, 90% of Italian credits now trade tight to similar maturity Italian government debt:
Not to put too fine a point on it, but that’s pretty damn incredible and it certainly seems to suggest that the ECB has made a concerted effort to support Italian credit with CSPP amid the ongoing political turmoil, even if they haven’t (yet) made a push to contain the blowout in sovereign spreads and/or cap BTP yields.
As I wrote last week, that seems unsustainable. Even if BTPs continue to selloff, you’ve got to think that Italian corporate debt would weaken to close the gap barring some kind of significant political U-turn that tips a more market-friendly outcome from the new government.
As BofAML writes, “Chart 12 suggests credit investors should tread carefully with respect to Italian credits at present [because] while corporate credit richness versus government debt can persist, we learnt during the peripheral crisis of 2011-2012 that eventually tight credits will reprice wider vs. govt debt (the best example of this was Telefonica).”
That leads naturally to this question: which Italian credits are trading richest compared to BTPs?
Or, more to the point, if one wanted to trade this, where would one look? BofAML has the following table on that: