Graphic content – October; Italian bonds are pricing >20% chance of default over 5 years
22nd October 2018
We find the market reaction to the ongoing Italian deficit drama baffling. As the chart below shows, Italy has been one of the best behaved fiscally over the last 10 years, and its deficit will be no worse (in fact better) than France and Spain’s in the next couple of years. It’s not in the interest of the EU to cause Italian bond market turmoil and risk the end of the Eurozone – not to mention the use of valuable political capital that the EU is deploying in this fight at a particular time of strong populist sentiment.
And yet the yield pick-up on Italy over Spain is now around the highest ever, and the spread on Italy over Germany is back to 2012 levels. The yield spread on Italy over Germany implies that bond markets are pricing in a 20% chance of an Italian default in the next five years, assuming a 40% recovery value. In all likelihood, if a default were to occur then the recovery rate would be more than this, given that the lowest recovery rate post a sovereign default was 35% in Argentina in 2001. If you relax the recovery assumption, the market is pricing in an even greater probability of default.
Italian government bonds therefore look better value at these levels, given the high probability of default currently priced in. If Italy were to default, there is the possibility that the contagion would spread to the rest of the Eurozone debt market, and cause a gigantic global financial shock. We cannot imagine that this would be allowed to happen, and Italian politicians probably know this.
Source: Bloomberg, 01/01/2004 to 31/12/2017. Forecasts for 2018 and 2019 are from the European Commission. Italy’s 2019 forecast comes from the Italian Government. Past performance is not a reliable indicator of future results.