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Italy Seen as Bigger Default Risk Than Indonesia: Euro Credit

Italy Seen as Bigger Default Risk Than Indonesia
Italian bonds have gained 1.1 percent in the past month and 4.5 percent this year as investors reward Italy for doing a better job of controlling its deficit than its euro-region peers. Photographer: Victor Sokolowicz/Bloomberg

Italy’s debt costs more to insure against default than that of the Philippines or Indonesia, as Europe’s financial woes overshadow a credit rating six levels higher than either of the emerging-market nations.

Credit-default swaps on Italy, the only borrower among Europe’s so-called peripheral nations not to suffer a cut in its credit rating since last year, trade at 165.5 basis points. That’s more than the 131 basis points for Indonesia, which had to restructure some of its debt in 2000, or the 129 basis points for the Philippines.

“Italy might be pricing in more default risk than it should,” said Johannes Jooste, a portfolio strategist at Merrill Lynch Wealth Management in London, which oversees $1.4 trillion in assets globally. “The emerging market is benefiting from ample liquidity which has artificially pushed the market too strongly, more so on the CDS than cash bonds.”

Italy’s credit default swaps reached a record high of 244.7 basis points on June 4 after Greece’s near-default fueled investor concern about the solvency of the euro-region’s most-indebted nation. The price of insuring Asian debt has dropped amid record demand for emerging-market bonds as investors wager those economies will drive the global recovery while Europe wrestles with surging budget deficits and sluggish growth.

The cost of insuring Italian government bonds against payment failure is also higher than that of Russia, which in 1998 defaulted on $40 billion of domestic debt.

‘Clear Demarcation’

Standard & Poor’s rates Italy at A+, six steps higher than its non-investment grade BB+ level for both the Philippines and Indonesia.

“We like Italy,” said Mohit Kumar, a fixed income strategist at Deutsche Bank AG in London. “There is a clear demarcation between Italy and the rest of the euro-peripheral world. Italy might be highly indebted, but its deficit- consolidation plan in the next five years is pretty much in line with what Germany has to do.”

The yield premium investors demand to buy Italian 10-year bonds instead of German bunds fell four basis points to a two-month low of 134 basis points, down from a euro-era high of 185 basis points on June 8. That compares with 158 basis points for Spanish debt, while Ireland and Portugal each pay a surcharge of more than twice that of Italy. Indonesian debt yields 471 basis points more than bunds.

Fund Flows

A record $40.5 billion has flowed into emerging-market bond funds this year, more than four times the full-year high of $9.7 billion in 2005, according to data from research firm EPFR Global. Indonesia, with a budget deficit of 1.5 percent of gross domestic product, grew 6.2 percent in the second quarter from a year earlier, while the Philippines, with a budget gap of 2.2 percent of GDP, expanded at an annual rate of 7.9 percent.

Italian bonds have gained 1.1 percent in the past month and 4.5 percent this year as investors reward Italy for doing a better job of controlling its deficit than its euro-region peers. Its shortfall of 5.3 percent of GDP last year is less than half that of Ireland, Greece and Spain, all of which had to cut wages and raise taxes to try to meet 2011 deficit-reduction goals.

“There is an element of Italian bonds being mispriced in this case,” Jooste said. “The Italian spreads have been volatile and they tend to follow peripheral stories. Our view on the peripheral market is that the market might have pushed it a bit too far. We expect the spread to pull in, although not to the pre-crisis level.”

Deficit Falling

Italy’s economy, the euro region’s third largest, is set to expand 1.2 percent this year and unemployment fell for a third month in August to 8.2 percent, less than the European Union average of 10.1 percent. The government intends to cut its budget shortfall to 3.9 percent of GDP next year and to limit any increase in the debt level to less than one percentage point, to 119.2 percent of GDP.

Even with deficit falling, investors remained concerned about Italy’s ability to cut debt given prospects for economic growth, said John Stopford, head of fixed income at Investec Asset Management in London.

“Perceptions of risk are changing,” said Stopford. “Developed economies in the near term are suffering from low growth, large debt levels and aging population while the emerging economies are doing well. Whether the market got that comparison right might be debatable, but people are quite right to reappraise risks.”

A basis point on a credit-default swap contract protecting 10 million euros ($13.9 million) of debt from default for five years is equivalent to 1,000 euros a year.

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

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