Sept. 11 (Bloomberg) -- The return of Italian bond futures next week after a 10-year absence may help traders better protect against price swings in Europe’s lower-rated debt than contracts tied to German bunds.

Ten-year Italian bond futures start trading on Eurex, Europe’s biggest derivatives exchange, on Sept. 14. F&C Asset Management Plc, Investec Asset Management and Aletti Gestielle SGR SpA said the contracts should enable them to hedge their holdings of Greek, Irish and Portuguese debt more effectively as the slump in those securities during the financial crisis caused the gap between their yields and benchmark bunds to widen to the most since the introduction of the euro.

“It will be very useful,” said Fabrizio Fiorini, a money manager at Aletti Gestielle in Milan, one of the 10 biggest holders of Italian bonds, according to data compiled by Bloomberg. “I can use it as a proxy” for the so-called peripheral bond markets, he said.

Italy, the most indebted nation in the European Union based on debt as a percentage of gross domestic product, first offered a futures contract in September 1991, when its bonds were denominated in lire. The contract, traded through Eurex rival Liffe, was discontinued in 1999 after the euro was created.

The new Italian contracts, known as BTP futures, will compete with the 700,000 German bund contracts traded each day on Eurex, according to data from the exchange. Futures are agreements to buy or sell assets at a set price and date. Investors can use the contracts to protect, or hedge, their investments against price fluctuations.

‘More Strategies’

BTP futures “will make it easier” to hedge, said John Stopford, who oversees $12 billion in assets as head of fixed income at Investec. “We may put on more strategies on periphery markets than we have done in the past.”

Demand for an alternative to German futures increased this year as the difference in yield, or spread, between the debt of so-called peripheral borrowers, or nations whose bonds are rated less than AAA, and bunds widened to records amid the worst recession since World War II.

The expansion in spreads made it “extremely difficult” to use German bund futures as a hedging tool for lower-rated debt as their correlation diminished, said Luca Cazzulani, a fixed- income strategist in Milan at UniCredit Markets & Investment Banking, a unit of Italy’s biggest lender.

That meant investors using the bund futures contract to hedge against potential losses of 1 million euros ($1.5 million) on 10-year Greek bonds would have just 550,000 euros of the assets protected, according to Cazzulani.

Rating Differences

Greek debt is rated A- at Standard & Poor’s, six levels below Germany’s AAA. Ireland has an AA rating at S&P, with Portugal at A+.

The extra yield investors demand to own government bonds other than those issued by Germany have narrowed as signs economies are stabilizing eased concern some borrowers would struggle to repay their obligations.

The spread between Italian bonds and German debt due in 10 years fell to 79 basis points today from 159 basis points on Jan. 27, the most since the euro was introduced in 1999. That compares with the average of 20 basis points over the five years before the crisis began in August 2007. The Greek-German spread was 134 basis points, down from 300 basis points on March 12. Portuguese and Irish spreads also narrowed. A basis point is 0.01 percentage point.

‘Liquidity is Everything’

“The volatility we’ve seen may have subsided, but the non- core spreads are still at elevated levels and may not return to the pre-crisis levels any time soon,” said Michiel de Bruin, head of European government debt at F&C’s Dutch unit, which manages $27 billion in fixed income assets. “We’re likely to use BTP futures to hedge our exposure to Italian bonds and possibly other peripherals if it’s liquid.”

Whether investors are able to buy or sell the futures without distorting prices will be the “most important” issue in determining if the market succeeds, according to Christoph Kind, head of asset allocation at Frankfurt Trust in Germany.

“Liquidity is everything,” said Kind, who manages $20 billion. “We will continue to use bund futures and swap products, which I find efficient, as our hedging tools. I doubt if the launch of the BTP futures will have any effect on our investment approach.”

Eurex said there will be seven market makers who will provide quotes when trading begins.

Demand Question

The new securities may struggle to generate demand should yield spreads return to pre-crisis levels, said Peter Chatwell, a fixed-income strategist in London at Calyon, the investment- banking unit of France’s Credit Agricole SA.

“Of primary concern is whether demand for the contract will be long term,” said Chatwell. “Prior to the crisis, the correlation between core and periphery was much higher. If the market was to return to that relationship, then demand for the BTP futures for hedging purposes would be lower.”

BTP futures also allow investors to avoid the counterparty risk they take on when hedging with credit-default swaps, said Nicole Elliott, a senior analyst in London at Mizuho Corporate Bank Ltd.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

“Exchange-traded products are good, especially when counter-party risk is still a major problem,” said Elliott, who traded BTP futures in 1992. “Your counterparty is a clearing house, and not another bank. It’s one small new weapon in our arsenal of hedging tools.”

To contact the reporter on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net

Last Updated: September 11, 2009 07:49 EDT