Fund managers are growing increasingly nervous Italy could lose its investment-grade credit rating, a development that would create upheaval in European bond markets.
Moody’s on Friday will become the first of the big three agencies to slap a “junk” label on Italian debt, if it downgrades Rome’s creditworthiness from the current Baa3 — the lowest rating still counted as investment-grade. Most fund managers think a demotion is unlikely, but even a change in Moody’s outlook on Italy’s creditworthiness from stable to negative would add to a sense that the country’s coveted top-quality rating is hanging by a thread.
Last week, Fitch unexpectedly cut its rating to the lowest investment-grade rung, on a par with Moody’s and one notch below rival Standard & Poor’s. The move reflected the economic pain being caused by Covid-19 and the extra debt Rome is taking on to fund its response.
“I struggle to see a path forward where Italy isn’t eventually downgraded,” said James Athey, a fixed-income portfolio manager at Aberdeen Standard Investments. “We are talking about one of the biggest bond markets in the world going to junk, where the vast majority of real money investors are involved. I can’t think of any precedent that even comes close.”
Even with a junk rating, Italy’s €2.4tn of government bonds would most likely retain the support of the European Central Bank, which has battled to keep borrowing costs down since mid-March by buying bonds through its €750bn pandemic emergency purchase programme. The central bank waived its usual investment-grade requirement to include Greece in the PEPP and could do the same for Italy.
But many investors such as pension funds and insurance companies are restricted to holding the highest-grade bonds, or at least have limits placed on how much riskier debt they can buy. Then there are trillions of dollars in passive investments that track the biggest bond benchmarks.
Rules vary between the main indices, but typically a bond issuer needs an investment-grade rating from two of the main three agencies to be included. That means a junk rating from more than one could spark a wave of forced selling.
Chiara Cremonesi, a fixed-income strategist at UniCredit, said rating-constrained investors “would not wait to become forced sellers” and are most likely to start offloading the debt when the first downgrade to junk comes. “Actually, those who are more sensitive to rating downgrades have probably already started to reduce their positioning,” she added.
The sheer size of Italy’s bond market dwarfs any other “fallen angel” — market parlance for bond issuers recently downgraded to junk — making it tough for traditional high-yield investors to absorb the sudden extra supply.
Peter Chatwell, head of multi-asset strategy at Mizuho International, said: “It would have a seismic impact on the relative size and importance of European investment-grade and high-yield indices, and would completely change the profile of the typical Italian government bond investor.”
In the event of a downgrade, most analysts think the ECB would have to buy Italian debt even faster amid an exodus of private investors — particularly the foreign holders who own more than a fifth of Italy’s debt.
“You’d be looking at a huge shift from private to public hands,” said Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers. He said that would keep a lid on borrowing costs in the short term, but investors might start to question the ECB’s ability to go on buying vast quantities of Italian debt once economies begin to recover. Another risk is the German constitutional court’s legal challenge to the central bank’s debt purchases, in a ruling earlier this week.
“On the pure economics Italy is junk; it’s only the ECB’s support that is keeping the rating agencies from acting,” Mr Ahmed said. “But how long that support lasts is a lot less clear than it was a few weeks ago.”
Fitch and S&P both highlighted ECB buying, which enables Rome to borrow relatively cheaply, as a crucial factor supporting Italy’s rating in their recent updates. But despite the central bank’s largesse, borrowing costs have been creeping higher, with Italy’s 10-year yield hitting a two-week high just below 2 per cent on Wednesday.
At some point that fall in the price of the debt could become self-fulfilling, as higher yields undermine the case for debt sustainability, spurring more investors to sell in anticipation of a downgrade, Mr Athey said.
“Typically, rating agencies are late to the party and just reflect what markets have already price in,” he said. “But as we approach that line in the sand between investment grade and junk, they really start to matter.”