Italian Bonds at Risk From Efforts to Break Bank-Sovereign Nexus

  • Nations fail to agree on limits to govt debt holdings by banks
  • Measures likely to kick in only after ECB QE ends: ING

Bonds from peripheral countries may be the most vulnerable to Europe’s effort to limit banks’ sovereign-debt holdings.

As European Union nations wrangle over ways to integrate and safeguard the region’s banking system years after the euro debt crisis, a major point of contention is how to deal with the government bonds banks have on their balance sheets.

While the securities are currently treated mostly as risk-free for regulatory reporting, Germany favors adding risk weights so that banks are less inclined to buy debt from the weakest nations. While these measures are likely to take some time to be ironed out and implemented, ING Groep NV’s Martin van Vliet, said he was keeping a close eye on discussions in an attempt to gauge its implications.

“Now there is basically a zero risk-weight on domestic sovereign bonds and also bonds of other euro-area countries,” van Vliet, the bank’s Amsterdam-based senior interest-rate strategist said. “I think the Germans are really pushing for risk weights depending on the rating, and that would be very unfavorable for the peripherals.”

Italy’s 10-year bonds fell on Monday, with the yield rising two basis points, or 0.02 percentage point, to 1.35 percent as of 12:55 p.m. in London. The 2 percent bond due December 2025 dropped 0.17, or 1.70 euros per 1,000-euro face amount, to 105.86. Spain’s 10-year bond yield increased two basis points to 1.51 percent.

Solvency Worries

While bonds from Italy, Spain and Portugal are supported by the European Central Bank’s 80 billion euros ($90 billion) a month asset-purchase program, domestic solvency worries are back in focus. Portugal’s government, for example, has a junk credit rating from three of four companies that follow it, while Germany is AAA-rated by all.

The banking crisis in Italy and Spain’s inability to form a stable government more than three months after the elections have weighed on the debt from these two nations. Portugal’s bonds have been among the worst performers this year in developed countries on concern that the nation will struggle to implement budget reforms required to complete its bailout.

In this environment, negotiations on the banking union have reached a stalemate, with Italy and France diverging from Germany to support limits on the concentration of debt that banks can hold. They have argued that makes it a more level playing field for stronger and weaker countries’ banks.

Spanish, Italian Banks

Increasing the costs to hold the debt “might have an effect in the longer term, if indeed Spanish and Italian banks might be forced to reduce their holdings,” said Allan von Mehren, chief analyst at Danske Bank A/S in Copenhagen. “But overall there is so much search for yield among investors still that I doubt it would have a too-big impact.”

Any measures agreed upon will likely be carried out only after the ECB winds down its QE program, van Vliet said. It’s currently scheduled to run until March 2017.

“It is very hard to predict what the outcome will be,” he said. With the ECB’s stimulus program supporting debt prices, “ongoing, big, sustained moves in the other direction are very difficult to envisage” for peripheral debt right now.

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