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Analysis: Cracks starting to appear in solid Italy bond market

People walk past the Duomo cathedral in downtown Milan January 11, 2013. REUTERS/Alessandro Garofalo
People walk past the Duomo cathedral in downtown Milan January 11, 2013. REUTERS/Alessandro Garofalo

By Marius Zaharia

LONDON (Reuters) - Chinks are showing in the Italian bond market's resilience to the political stalemate that followed last month's election.

Backstopped by the European Central Bank's bond-buying pledge, Italian yields have been relatively steady at levels well below their all-time highs since the Feb 24-25 vote which left parties deadlocked over how to form a government.

But some potential signs of market stress are emerging.

Italian bonds paying lower rates of interest have outperformed higher-coupon paper of similar maturity in recent weeks - a phenomenon that occurs in times of heightened uncertainty, when investors take defensive positions.

"It is one of the crisis barometers," said Commerzbank rate strategist David Schnautz. "When you have stress in the system you see certain dislocations, switches in the curve."

While yields on the two types of bonds are similar, those offering smaller coupon payments are generally cheaper to buy, reducing the potential loss for the investor if the issuer cannot repay its debts.

A sovereign borrower with liquidity problems would also be more likely to delay coupon payments than not redeem the bond at maturity, analysts say.

The discrepancy in price is most visible at the longer end of the Italian debt curve, where the difference between coupons is also wider.

A bond maturing in August 2023 and carrying a 4.75 percent coupon was priced at 101.53 cents in the euro this week, while a November 2023 bond paying a coupon of 9 percent was priced at 134.87 cents in the euro.

The August bond has outperformed in recent weeks, widening the difference in yields between the two bonds so that the higher-coupon November paper currently offers investors an additional return of about 21 basis points.

That is the biggest differential since early January and a jump from just 10 basis points - the smallest gap since December 2010 - before last month's vote, although still well off wides of more than 100 basis points hit at the end of 2011.

Then, with former Prime Minister Silvio Berlusconi still at the helm, Italy's borrowing costs soared to unsustainable levels and markets feared its debts would spiral out of control.

Yields have since fallen sharply, with the ECB's as-yet untested pledge in September to buy bonds of euro zone countries that seek aid underpinning valuations.

"In the old days the difference was very pronounced. I'm not saying we're heading towards that now, I'm just saying it's something we need to watch," Schnautz said.

In France, regarded by investors as one of the euro zone's safest credits, the yield differential between similarly-dated bonds has been more stable.

The spread between an April 2023 bond with an 8.5 percent coupon and a 4.25 percent October 2023 bond has held within a 17 basis point range for the whole six years the two bonds have been neighbors on the curve.

INVESTMENT OPPORTUNITY

Credit Agricole rate strategist Peter Chatwell said that while low-coupon bonds can indicate debt market tensions, the steepness of the Italian curve - the difference between short-dated and long-dated yields - suggested limited stress.

A steep curve is seen as healthy as it shows investors do not see an immediate risk of default. An inverted curve, when short-dated yields are higher than the long-dated ones, is the clearest sign of a distressed debt market.

The spread between benchmark 10-year and two-year Italian bond yields was last 284 basis points. At the height of the crisis in 2011, the spread was negative at almost minus 50 bps.

"When there was a big bear flattening of the curve there (were) switches out of high-price paper into lower-price paper ... which could be due to a perception of an inflated risk of default," Chatwell said.

"It's wrong to do that in this environment and we've flagged it as an opportunity for investors to buy the higher coupon bonds."

(Editing by Nigel Stephenson and Catherine Evans)

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