Which way now for Italian government bonds?

About one year ago the famous Bund/BTP spread was still hovering in the mid-400s. One year hence, and in the midst of arguably one of the most complicated political situations post WWII, this spread has fallen to below 250bps. How do we explain this remarkable performance? For starters, as the previous Italian finance minister said last year, about half the 450bps of spread of mid 2012 was due to Europe’s crisis, and the other half to Italian issues. The European crisis has abated for the time being, while Italy’s politics are as complex as ever and its stock of government debt at all-time high.

If the above weight attribution of the cost of Italian debt is correct, one would be hard pressed to see the investment case for buying BTPs at this time. Given that about 50-80bps of the remaining 250 are to be considered ‘physiological’, the ‘extra spread’ is now only about 170bps. This extra spread is a function of political stability and Debt/GDP. The latter is, as we said, hovering at all-time high well over 100%, with any hope of contraction tied mainly to renewed growth to bring the denominator up. The former, given the volatility of the Berlusconi issues, the continued lack of leadership in the PD and the still large 5-Star movement, is not likely to produce good news in the short term.

In summary, Italian bonds have had a nice ride, but at this time, we would suggest that savvy investors will stay out if not play it from the short side.