Italy's bond yields up after S&P downgrade

Wednesday 10 July 2013 11.12
Standard & Poor's cut Italy's sovereign credit rating to BBB from BBB+
Standard & Poor's cut Italy's sovereign credit rating to BBB from BBB+

Italian bond yields rose slightly today after a Standard & Poor's downgrade.

S&P cut Italy's rating by one notch to BBB and left its outlook negative, citing the country's weak economic prospects and impaired monetary policy transmission within the euro zone.

Italian 10-year yields rose seven basis points to 4.47%, while two-year yields rose six bps to 1.88%.

Analysts said market reaction to the downgrade had been muted as Italy's ratings remain two or three notches above "junk" grade, meaning investors have not been forced by their own credit quality rules to sell.

Also, two-thirds of Italian debt is held by a relatively diverse base of local investors, which tend to hold onto its bonds.

The premium offered by Italian and Spanish 10-year bonds over German Bunds has halved in the last year after the European Central Bank promised to buy government bonds of countries under market pressure that ask for financial help.

According to Bank of Italy data, banks - which tend to favour short-dated bonds - held about a fifth of total Italian debt at the end of September 2012, a much smaller share than in Spain, where they hold about 40%.

But about a quarter of Italian debt is held by local insurance companies, pension funds, households and corporates. In Spain, insurance and pension funds, which are more likely to invest in longer dated debt, hold about 10%.

Traders said comments yesterday by European Central Bank policymaker Joerg Asmussen indicating the bank would keep rates low for more than a year, and the release later of minutes of the Federal Reserve's June meeting were also limiting the market reaction to the downgrade.

Rated just one notch above junk by Moody's and S&P, Spain would be more vulnerable than Italy to a downgrade that would force investors who only hold investment-grade debt to sell.

Spanish 10-year bond yields were eight basis points higher at 4.77% today, while other indebted euro zone countries' bonds were stable.

"The rating action reflects our view of the effects of further weakening growth on Italy's economic structure and resilience, and its impaired monetary transmission mechanism," S&P said in a statement.

Italy's economy, the euro zone's third largest, has been one of the most sluggish in the world for over a decade, held back by low competitiveness, a weak political system and a public debt of more than 130% of gross domestic product.

S&P noted that economic output fell 8% between the final quarter of 2007, on the eve of the global financial crisis, and the first quarter of 2013, and said data pointed to a sharp drop for the year as a whole.

It cut its full-year economic forecast to show a contraction of 1.9%, in line with a forecast by the International Monetary Fund last week.

The recession is making it more difficult for Prime Minister Enrico Letta to hit European Union budget targets while meeting demands from his centre-right coalition partners for tax cuts.

Letta himself said the rating cut showed that Italy was still far from overcoming the long slump that took the euro to the brink of collapse in 2011. "It's proof that the situation is still complex and Italy remains under special observation," he said on Italian television last night.

Successive Italian governments have passed a succession of severe tax hikes and spending cuts to keep the deficit under control and Rome has emerged from the EU's special excessive deficit procedure, which Letta hopes will ease budget pressure.

However S&P said the main problem was a lack of structural reform to put the economy on a sustainable path toward growth. "In our view, the low growth stems in large part from rigidities in Italy's labor and product markets," it said.

It pointed to data from the European Union statistics agency Eurostat which showed that nominal unit labour costs had increased more than in any other major member of the euro zone, underlining a sharp decline in productivity.

With the government at odds over issues ranging from demands to cut an unpopular housing tax to an order for F-35 combat jets and the legal problems of centre-right leader Silvio Berlusconi, prospects of concerted political support for reform appear weak.

Fitch rates Italy BBB-plus with a negative outlook. Moody's rates the country Baa2 with a negative outlook.