Spain's Quagmire Is Punishing Investors With Riskier Premiums

  • Most analysts in survey apply or plan to apply a risk spread
  • Investors turn to Italian bonds as recovery gains traction

Spain’s economy has roared back to life, so why are investors more bearish? 

Catalonia’s push to break free in an increasingly fractured political landscape have rattled bond holders, who are now demanding better returns to own Spanish sovereign debt instead of Italian government securities.

Spain may be the second-fastest growing economy in the euro area, yet investors fear a messy general election in December will end in deadlock with upstart parties as king makers. Almost two-thirds of the 22 analysts surveyed by Bloomberg apply or plan to affix a relative risk premium to Spanish bonds compared to Italian securities, the natural alternative for investors exposed to European peripheral economies.

“The Spanish bond spread could widen further until the dust settles on the new political landscape in Spain, that means until the next central government is sworn in and the Catalan case is settled,” said Raphael Gallardo, a Paris-based strategist at Natixis Asset Management, which oversees 328.6 billion euros ($371 billion) of assets including Spanish and Italian debt.

The extra yield investors demand to hold Spanish ten-year bonds instead of similar duration securities is near the highest since July 2013, when Spain was battling to return to growth after an 18-month recession. Now it’s set to grow at 3.3 percent, almost five times the pace of Italy.

Regardless, Prime Minister Mariano Rajoy is struggling to convert economic good news into political capital -- a poll this month shows his People’s Party in a virtual tie with the rival Socialist party -- and market goodwill.

Investors demand an extra 24 basis points to hold Spanish debt instead of Italian securities, close to the 27.5 basis points on Sept. 11, the highest in almost two years, according to data compiled by Bloomberg. That compares with a 30 basis-point risk spread which investors should apply to the Spanish debt over Italy’s, going by the median estimate of what analysts surveyed by Bloomberg are pricing in.

Since July, the tide has turned against Spain after an 18-month idyll during which the Iberian country enjoyed lower relative borrowing costs. As things stand, the Italian Treasury can place debt due in three years or longer duration at lower yields than Spain, Bloomberg compiled data show.

The political uncertainty is prompting investors to shift their focus away from Spain’s economic performance. The first hurdle is a Sept. 27 parliamentary election in Catalonia, the country’s third-wealthiest region, that has been touted as a proxy vote on independence. Different separatist factions could also join forces to try and influence the general ballot.

Other election spoilers include two relative newcomers: Podemos, a protest movement turned anti-austerity party that resembles Syriza in Greece, and Ciudadanos, a pro-business party with a libertarian slant in its support for the legalization of prostitution and marijuana.

The bottom line is that even if Spain’s economic fundamentals are solid, even better than Italy’s, right now it’s all about political risk.

“A positive general election outcome -- i.e. no anti-establishment party in power -- would make Bonos a roaring buy in my opinion,” said Alan McQuaid, chief economist at Merrion Capital Group in Dublin.

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