Italian Bond Revival Begins as S&P Holds Fire on Rating Cut

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Italy’s populists and debt market have made it through a brace of credit rating reviews that threatened to further blow out the nation’s borrowing costs just as they saddle up for the next stage of a budget standoff with the European Union.

The country’s bonds jumped as European markets opened Monday after S&P Global Ratings lowered its outlook on Italy to negative Friday and kept the sovereign rating unchanged at two notches above junk. That follows a short-lived relief rally a week ago after Moody’s Investors Service cut the rating but kept it at investment grade.

The latest review “removes for a few months the large downside risk that existed prior,” Adam Kurpiel, head of rates strategy at Societe Generale SA, wrote in a client note ahead of the announcement. The current high yields on Italian bonds "give sufficient compensation for risks for now and into year-end."

The decisions by the rating companies to keep Italian debt above the junk threshold may strengthen the hand of the nation’s coalition government as it seeks to push through proposals that are in breach of the EU’s fiscal rules. An investment-grade ranking assures the presence of its bonds in global benchmarks and the European Central Bank’s asset-buying program, providing a guaranteed level of support.

The Five Star Movement-League coalition has come under pressure from markets in recent months as the yield spread on its bonds versus those of Germany reached the highest level since the euro-area debt crisis. Cabinet Undersecretary Giancarlo Giorgetti said last week that bank bailouts may come into play again if the 10-year spread crosses 400 basis points.

“The bargaining process needs to be handled pretty carefully because whether the ECB steps in to help the Italians or not is the key question,” Aninda Mitra, senior sovereign analyst at BNY Mellon Investment Management, which oversees $1.8 trillion in assets globally, said in Singapore. “I don’t think either side wants to take it to the extent where they make a horrible example out of Italy and get the market to force an adjustment.”

Italy’s 10-year yields fell 10 basis points to 3.35 percent by 7:30 a.m. in London, narrowing the spread over German bonds to below 300 basis points. The difference between the two touched 341 basis points earlier this month. ING Groep NV estimated the spread could narrow to 250 basis points if S&P didn’t downgrade, especially if a budget compromise is reached with the EU.

Italy has three weeks to resubmit its budget to the EU, while its own parliament has to approve the budget law by year-end.

While the euroskeptic firebrands in Prime Minister Giuseppe Conte’s administration have embraced a war of words with the European establishment, some officials in Rome have flagged concern about how the escalating bond yields could affect the country’s banking system.

The country’s banks are still sitting on 260 billion euros ($300 billion) of non-performing loans from the last financial crisis.

“It’s a long fuse, and Italy’s a big deal -- this is not Greece,” said BNY Mellon’s Mitra. “I suspect we’re still at the early-to-middle stages of the bargaining process that’s playing out.”

— With assistance by Ben Sills, and Ruth Carson

( Updates first and seventh paragraph to reflect price changes.)