January 26, 2012 / 10:43 AM / 6 years ago

Analysis: Italy - a buy for the brave

DAVOS (Reuters) - Italy could turn out to be the investment bet of the decade if European Union leaders manage to contain the euro zone crisis.

<p>An Italian flag waves in front of the Montecitorio palace before the start of a finances vote in downtown Rome November 8, 2011. REUTERS/Tony Gentile</p>

But buying Italian debt at this time is only for the brave - and those who believe the worst of the danger for the euro zone’s third biggest economy has passed, according to interviews with more than a dozen investors and bankers.

George Soros called returns above 6 percent on 10-year Italian debt a “dangerous” but “attractive” speculation.

“That’s a fantastic yield, which is not going to stay up there the moment things settle down,” said Soros, once the world’s best-known hedge fund manager. “At 6 or 7 percent, Italian bonds are a speculation. At 5 percent or 4 percent I think they would be a very, very good long-term investment.”

Ten-year Italian bonds have been one of world’s best performing assets since the start of 2012, beating a 6.4 percent annual return offered by traditional safe-havens such as gold.

The prospect that new prime minister Mario Monti, an internationally respected economist, will put Italy’s house in order after decades of lax fiscal policy is lifting some of the gloom. But with uncertainty still hanging over the future of the euro zone, the difference in returns offered by 10-year Italian bonds compared with equivalent German bonds, currently just above 4 percent, would have to fall by at least 1 percentage point to attract substantial inflows.

In order to engage in this type of bet, one has to be convinced that the euro zone will survive a looming Greek debt restructuring and projections of prolonged slow growth.

Several non-European investors interviewed by Reuters were uninterested in buying the bonds of Italy, Spain and other weak European states because they were not convinced politicians will achieve a lasting solution to Europe’s woes. But there is a play to be made if one has faith in Europe’s leaders.

“We are sitting on a bomb now. If the bomb explodes we are all dead. But if it doesn‘t, Italy is a better place to be than Germany,” said a hedge fund manager, speaking on condition of anonymity because of the sensitivity to his business.

Germany is one of only four euro zone countries still rated AAA by Standard & Poor’s and is the only one with a stable outlook. That contrasts with the BBB+ S&P slapped on Italy in a mass downgrade of the euro zone on January 13.

ECB FUNDING GAME CHANGER

Some investors and bankers say the chances that the 17-nation single currency bloc will find a way out of its crisis have improved since the ECB decided in December to start offering unlimited 3-year funding to European banks.

The cheap money flow, known as Long Term Refinancing Operation, is throwing a lifeline to European banks that risked being shut out of the funding market back in October and November, preventing a Lehman-type bank failure that could have destroyed the single currency only three months ago.

“The issue of liquidity as far as the banks are concerned seems to have abated, yet there are other issues. It is a policy that provides breathing space for other policy measures to take place. By and large it’s a very good measure,” said Jacob Frenkel, Chairman of JP Morgan Chase.

The ECB funding, offered at 1 percent in exchange for collateral such as government bonds, has led to more demand for Italian sovereign debt because banks can use the cheap funds to make potentially lucrative bets. This carry trade is causing yields on short-term bonds to drop. Two-year Italian government bond yields have more than halved from the high of 7.5 percent seen at the end of November.

“Many hedge funds who were betting on Italian government bonds selling off have either changed views and taken profits or have been stopped out of their positions as the market has gone against them,” said M&G Investments.

Bank executives and analysts say Italian short-dated sovereign debt has been attracting more interest among foreign investors since the start of the year. But it is Italian buyers who are snapping up the lion’s share of it at auctions. The real test for Italy will be whether it can attract interest on its benchmark 10-year bond. Italy is due to sell five and 10-year BTP bonds on January 30 at an auction that will settle on February 1 when nearly 26 billion euros of BTPs and about 10 billion euros in coupons mature.

“What we see now is the cautious and selective return of non-domestic buyers,” said Giovanni Bossi, CEO of small Italian lender Banca IFIS, who says his bank nearly doubled the amount of Italian bonds it held to 3.7 billion euros between Christmas and New Year. “Italy’s MTS bond market was completely shut in November. The new ECB funding facility has unblocked it.”

The Italian Treasury does not disclose data on buyers of its bonds at auctions nor does it give a breakdown of types of investors holding its debt. Analysts estimate that at the end of 2011 foreigners held about 45 percent of the country’s debt With the rest in the hands of domestic banks and retail investors.

DEBT MOUNTAIN

Italy has a 1.9 trillion euro public debt, too large for anyone to absorb should things turn ugly in the euro zone. At around 120 percent, the country’s debt to GDP ratio is the third highest in the world behind Japan and Greece. But thanks to an average maturity of 7 years, at par with France and longer than AAA-rated Germany, new debt issued at current yields has only a marginal and gradual impact on overall debt-servicing costs.

The country is running a primary surplus, projected at 3.4 percent in 2012, and can continue to service its debt if yields do not blow out for a prolonged period of time. According to Bank of Italy data, even with zero economic growth for the next three years and yields of 8 percent, Italy’s debt-to-output ratio would remain stable.

Prime Minister Mario Monti is also stepping up efforts to reach a balanced budget in 2012. He plans to liberalize the economy and step up pension and labor market reform in order to revive growth.

“We are positive about the measures proposed by Mr. Monti’s government. According to our calculations Italian debt to GDP will decline in coming years if all the announced measures are implemented,” said Angelien Kemna, Chief Investment Officer at APG, which advises Dutch pension funds with assets worth 205 billion euros. “Our simulations show that that implementation has a much bigger impact on the debt/GDP ratio in 2016 than a higher yield level or a somewhat weaker growth rate.”

As Italy moves to reduce its debt, the amount it has to pay in interest to bond holders can be expected to fall. Yet the International Monetary Fund is expecting Italy to enter a recession this year and suffer a 2.2 percent decline in output, limiting its ability to reduce debt.

SCEPTICISM ABOUNDS

The Italian government is working hard to woo foreign investors. Monti has skipped Davos this year, sensitive to the gathering’s excesses at a time of austerity at home. Instead he was in London last week to try to overcome widespread euro-skepticism in Europe’s financial capital.

Deputy Economy Minister Vittorio Grilli, who was also meeting potential bond-buyers in London on Wednesday, said London-based investors showed “impressed surprise” at the progress made by Italy in fixing its public finances and reforming the economy.

Betting on Italian bonds may be an attractive trade for sophisticated investors like hedge funds, but for the super wealthy who want to preserve their capital with minimal risk it is still a no-go area. That is why private bankers are not advising wealthy clients to dip into Italian and other peripheral bonds.

“We are advising clients to stay out of the periphery of the euro zone. You do not want to take a large amount of risk. The main concern right now is capital preservation,” said Jane Fraser, head of Citi Private.

Large non-EU pension funds, some of whom have restrictions on investing in foreign government debt, are staying away from Italy or have reduced their exposure. Norway’s mammoth sovereign wealth fund, for instance, reduced its holdings of Italian government debt in the third quarter of 2011 as the euro crisis approached its most acute phase.

Nervousness about the ultimate outcome of the crisis is also scaring off some Asian and U.S. funds that find the complexity of the euro zone architecture daunting.

“We will not invest in European sovereign debt. It’s not our area of expertise, and the little we invest won’t make a difference anyway. Such investments are best left to governments or state-backed companies, because only they have the resources to help improve things,” said John Zhao, CEO of PE fund Hony Capital with almost $7 billion under management.

Additional reporting by Valentina Za and Silvia Aloisi in Milan, Sinead Cruise in London, Kelvin Koh and Alex Smith in Davos; editing by Janet McBride

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