Italy, Spain Stuck in No-Go Zone at Merrill, DWS: Euro Credit

A European Union Flag Flies With The Greek National Flag
Merrill Lynch Global Wealth Management, unconvinced that the second Greek bailout has stemmed the debt crisis, won’t put any of its $1.5 trillion of assets into Italian or Spanish bonds. Photographer: Kostas Tsironis/Bloomberg

Merrill Lynch Global Wealth Management, unconvinced that the second Greek bailout has stemmed the debt crisis, won’t put any of its $1.5 trillion of assets into Italian or Spanish bonds.

The unit of Bank of America Corp. has spurned bonds from Greece, Portugal, Ireland, Spain and Italy since deciding to avoid them in April of last year, according to Johannes Jooste, a senior Merrill portfolio strategist in London. Merrill isn’t alone: Frankfurt-based DWS Investment, which oversees $390 billion for clients, and Legal & General Investment Management say they are “underweight” Spanish debt.

The lack of enthusiasm from bond buyers threatens the latest rescue deal for Greece, which was struck two weeks ago to reassure investors as contagion from the debt crisis sent Italian and Spanish bond yields soaring. The bailout includes contributions from banks and other private bondholders through a series of exchanges and buybacks that will cut the debt load.

“We are not convinced that this is the finality of the haircuts,” Jooste said in an interview, referring to losses absorbed by those private investors through the debt-exchange program. “There is still a question mark of whether there will be haircuts for countries apart from Greece.”

Legal & General said its $500-billion fund is “neutral” on Italian bonds and holds fewer Spanish securities in its portfolio than recommended by benchmarks used to measure the fund’s performance, a so-called underweight position.

Debt Load

Last month’s rescue agreement also consists of 109 billion euros ($155 billion) from governments and the International Monetary Fund.

Italy, whose 1.8 trillion euros of borrowings make it the region’s biggest bond market, will have the second-highest debt level as a percentage of gross domestic product this year, according to a May 13 European Commission forecast. At 120 percent, it will trail only Greece’s 158 percent. Spain’s 68.1 percent level will be less than that of France and Germany, though its budget deficit, at 9.2 percent last year, was below only Greece and Ireland.

Yields on Italian and Spanish bonds have resumed their ascent after declining when European leaders agreed July 21 on the aid package for Greece, the second in less than two years.

The extra yield investors demand to hold 10-year Italian bonds instead of benchmark German bunds rose to 384 basis points today, the most since the euro was introduced more than a decade ago. Spanish 10-year yields have jumped 55 basis points to 6.3 percent since the summit.

Peripheral Yields

Yields on other peripheral bonds also rose today as concern over the region’s debt problem and speculation that the U.S. debt-limit compromise would damp global growth prompted investors to look for a haven. Ten-year Portuguese bond yields climbed 15 basis points to 11.06 percent, while Greek yields of the same maturity gained 9 basis points to 14.86 percent.

“The recent solution for Greece has not changed our perception about the peripheral market, and we are not quite sure if the problem is contained,” said Ralf Schreyer, head of European fixed income at DWS. “The key word here is trust. If policy makers spoke with one clear voice, we would have had more trust that they are committed to the solution, that they are heading towards the right direction.”

The additional yield investors demand to hold 10-year Spanish debt over bunds reached a euro-era record of 404 basis points today, compared with the average 44 basis points in the past decade.

‘Danger Zone’

Spain is still in “the danger zone” and must keep up momentum in restructuring its economy to stave off contagion, the International Monetary Fund said last week. The report followed a warning by Moody’s Investors Service that it may downgrade the euro region’s fourth-largest economy further.

Moody’s cited “funding pressure” when it placed Spain’s Aa2 rating on review for a cut on July 29. It said Spain’s regions are struggling to cut budget deficits and the Greek bailout increases the risk that bondholders will have to pay for rescues in other countries.

Yields on 10-year Spanish and Italian bonds are only about a percentage point away from the 7 percent mark that prompted Greece, Portugal and Ireland to seek bailouts. Rising borrowing costs and a poor growth outlook are two reasons Jonathan Cloke, a portfolio manager at Legal & General, cited for holding off on purchasing of Italian and Spanish government securities.

In addition to being underweight Spanish bonds, Legal & General no longer owns Greek, Irish and Portuguese debt.

ECB Outlook

“I don’t think Italy and Spain can carry on financing at the current yield levels,” said Cloke. “There will have to be some ways of reducing their interest rates, although I’m not quite sure how. And with the European Central bank expected to keep raising interest rates, I’m worried these countries are not going to get growth they need to reduce debt.”

The ECB has already increased its benchmark rate twice this year, bringing it to 1.50 percent in July. It will reach 1.75 percent by the end of this year, according to a weighted-average of 37 forecasts compiled by Bloomberg.

Italy sold 10-year bonds at a yield of 5.77 percent on July 28, compared with 4.94 percent at the previous auction in June. Investors are demanding higher yields from Italy even as the country’s growth is underpinned by exporters and, unlike other troubled countries, more than half of its debt is held by local investors.

Moody’s comments on Italy on June 17 cited “risks posed by changing funding conditions for European sovereigns with high levels of debt.”

Italian Data

Sales of Italian goods abroad climbed 1.4 percent in the first quarter of this year, up from the fourth quarter when exports rose 0.4 percent, Italian data released June 10 showed.

“You may argue that Italy’s economic fundamentals are different, but the country, with its huge debt load, is as vulnerable as others when borrowing costs rise,” said Mark Dowding, a fund manager at $39-billion BlueBay Asset Management in London. “Italy is solvent when it can borrow at 4 to 5 percent. When the costs rise well above that, its solvency is called into question. We are cautious about Italian bonds.”

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