Shrinking Yield Gap Masks Berlusconi Risks: Euro Credit

Italian borrowing costs relative to Germany are shrinking as bund yields climb, in turn masking investor concern about the potential for political turmoil, credit-default swaps suggest.

The cost of insuring Italian government securities against default has risen 8.5 percent since reaching a low for the year in May. The yield premium investors demand to own its 10-year bonds rather than German bunds dropped to a two-year low last week. The correlation between bonds and derivatives is at its lowest level since January, based on data compiled by Bloomberg.

Evidence of an economic rebound in the euro region has pushed German yields higher while underpinning demand for Italian debt, even as former Prime Minister Silvio Berlusconi’s party threatens to withdraw from the coalition government. The increase in German rates was exacerbated by speculation that the U.S. Federal Reserve will soon scale back its bond purchases.

“Italian yields are out of whack with its political situation,” said Robin Marshall, who helps oversee about $22 billion as director of fixed income at Smith & Williamson Investment Management in London. “Some investors may have expressed their bearish view through the CDS instead of selling the underlying bonds. It’s more the case of German yields being pushed higher by concern about the Fed’s tapering than a reflection of progress in structural reforms in Italy.”

Tax Fraud

Berlusconi, 76, was convicted of fraud linked to tax evasion in the purchase of U.S. film rights for the ex-premier’s broadcast company Mediaset SpA. The stability of Italian Prime Minister Enrico Letta’s four-month old coalition was called into question after Berlusconi’s People of Liberty party threatened to withdraw its support if Letta’s Democratic Party votes to end the former prime minister’s mandate as senator.

The 60-day correlation coefficient between Italy’s yield spread and its default swaps is down to 0.68, the least since January, from 0.92 in April. A coefficient of 1 means the two values move in lockstep, while zero shows no relationship and minus 1 shows they move in the opposite directions.

The difference between yields on Italian 10-year bonds and similar-maturity German bunds is about 252 basis points. It touched 227 basis points on Aug. 19, the least since July 22, 2011. The spread widened to a euro-era record of 575 basis points on Nov. 9, 2011.

Fractured Coalition

Italy’s upper house is set to vote on expelling Berlusconi from the Senate. The Senate committee for immunity and elections will discuss the issue on Sept. 9, according to the upper house press office. The process may take weeks before a final vote by the entire chamber follows.

“If in a private company, a partner reports another one or tries to get rid of him, the business doesn’t exist anymore,” Renato Brunetta, chief whip of Berlusconi’s party in the parliament’s lower house, said on Aug. 22. The PD “would provoke the government’s fall,” he said.

Italy’s borrowing premium has dropped amid speculation the Fed will start tapering bond purchases, which pushed bond yields in core markets up at a faster pace than those of peripheral securities. Ten-year Italian bonds yield about 4.40 percent, down from as high as 4.96 percent on Feb. 27. The yield on German bunds rose to 1.98 percent on Aug. 23, the highest since March 2012, and is currently about 1.87 percent.

The U.S. central bank will reduce its monthly purchases of $85 billion in bonds at its Sept. 17-18 meeting, according to 65 percent economists in an Aug. 9-13 Bloomberg survey. The median estimate is for a cut to $75 billion each month.

Broken Economy

“Financial markets are worrying about the wrong thing,” said Neil Williams, chief economist at London-based Hermes Fund Managers, which oversees about $40 billion. “They seem hypersensitive to a withdrawal of U.S. stimulus, rather than a euro-region that’s not yet fixed. The convergence we’ve seen in yields is doubtless a symptom of the complacency that’s being attached to the euro-region.”

Berlusconi, a three-time premier, retains influence over the government even after Italy’s top court rejected his final appeal earlier this month. He is unlikely to spend time in jail, given Italy’s effort to reduce prison populations and the leniency traditionally accorded to criminals over the age of 70. He maintains his innocence.

While recent economic data suggested the worst may be over after the euro region’s longest recession, the recovery was led by Germany, which grew 0.7 percent in the second quarter. Italy’s economy shrank 0.2 percent.

‘Political Risk’

Standard & Poor’s cut Italy’s credit rating to BBB on July 9, its second-lowest investment grade, citing weaker growth and budget targets that are “potentially at risk.”

The shrinking bond spread was also driven partly by the fact that Italy hasn’t issued any conventional bonds so far this month. Sales of those securities will resume on Aug. 29, the government announced today.

“The Italian-German bond spread may widen further to 270 basis points once the debt sales resume, especially if the lingering political risk worsens,” said Nick Stamenkovic, a fixed-income strategist at RIA Capital Markets in Edinburgh.

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