"It seemed like a good idea at the time....."

Thursday 17th November 2016

  

"It seemed like a good idea at the time....."  --  Italy's long bond and the small matter of a referendum .....

ref:- "Italy's 50-year bond tanks on political risk", The Financial Times. Capital Markets, Markets and Investing

ref:-  "After Trump and Brexit, All Eyes are on Italy's Constitutional Referendum", The Wall Street Journal

How big a part does political risk play in your investment decisions? For the buyers of Italy's new 50-year bond issue in early October, not too much it would seem. Either that or they take political risk very seriously but just aren't too hot at assessing it. Of course, one could argue's that the global sell-off in bond markets has been caused by the election of the high-spending, tax-cutting, inflation-boosting Donald J. Trump. That was a political risk if ever there was one and not many saw that coming, so why pick on Italy's long debt?  Well, how about ..... BECAUSE IT'S ITALY, and what's more it's Italy with a bad loan / banking crisis and with a crucial referendum hanging over it.

Now don't get us wrong here ..... we bow to no one in our admiration of that fine nation and its many virtues, but with the best will in the world one could never say that political stability was one of them. There have been 63 governments in Italy since the end of WW2  --  that's an average of one every 1.13 years. At that rate, we could see 44 new governments in Rome before the bond reaches maturity. That alone might encourage a little caution amongst investors one might think, especially when Italy is saddled with a  massive debt-to-GDP ratio of 135% and a history of fiscal excess.

Apparently not ..... at least not for those who were prepared to commit to long-term Italian debt in return for some kind of yield when alternatives are hard to find. There was no shortage of investors. The 5bn euro issue was met by 18bn euros worth of bids, and the government managed to get the sale away at a coupon of just 2.85%  --  this is a 50-year bond we're talking about, remember. At the height of the financial crisis, Rome was having to pay that for 2-year notes. Well done to them for locking in borrowing at such cheap levels for so long whilst they can.

Sadly, things have not gone well for those brave buyers. In a little over six weeks, the price of the bond has dropped 14%. We can hazard a guess that the idea of government debt, even at the long end, being one of the safer investments does not have many supporters amongst this lot of bondholders.

France, Belgium and Spain have all issued 50-year paper in 2016, and Austria has gone out as far as 70 years. All have suffered in the global bond rout  --  longer bonds are particularly sensitive to expectations of inflation as it eats into FIXED coupon payments  -- so again, why the focus on Italy? Because it's the worst performer certainly, and because of the one issue that is foremost amongst the problems specific to Italy  --  the constitutional referendum on December 4th.

Now, if we're talking political risk, this is right up there. By way of a reminder ..... Italians will vote on whether to give the go-ahead to reforms designed to strengthen the power of government (and to make it easier to pass new law) by reducing the size and power of the Senate in the bicameral parliamentary system. Prime Minister Matteo Renzi is behind the new proposals and has threatened to resign if they are rejected. That could make things a bit awkward ..... polls suggest that the "No" vote is narrowly in front, albeit with the very large proviso that about a quarter of voters are still undecided.

One could make the obvious point that after recent events anyone putting their trust in polls needs their head examined but plainly nerves are jangling in Rome, the EU and the ECB. Rumour has it that several EU heavyweights have been privately suggesting that Italy represents the biggest threat to European financial stability. At the same time, financial markets have shown their concern by widening the yield spread between 10-year German government debt and its Italian equivalent, compressed to around 1.00% by QE bond buying at the start of the year, to 1.74%. Things are getting a wee bit sweaty .....

Okay, we'll play devil's advocate ..... or rather, let the WSJ do it for us. Their worst-case scenario:

"A defeat for Mr Renzi would lead to a period of political instability. Mr Renzi could follow through on a pledge to resign or be forced into a new coalition until elections are held in 2018. Either way, markets would interpret his defeat as proof that Rome is incapable of reform, raising doubts about Italy's ability ever to deliver the kind of growth needed to put its debt burden of 135% of GDP on a sustainable footing.

"That in turn would make investors even more reluctant to put capital into the Italian banking system, forcing banks to impose losses on bondholders, many of whom are ordinary savers. That would create a spectacular political backlash that could bring the deeply eurosceptic, anti-establishment 5 Star movement to power in 2018, putting Italy's Euro membership in doubt".

Mmmm..... interesting, in a dark and deeply pessimistic sort of way. It's not necessarily the most likely outcome but it is a fine example of political risk and one that investors would ignore at their peril. At the very least, it deserves consideration.

Ciao!