Battle of the BTPs and Bonos

It’s Europe’s least-loved debt, after Greek, Irish and Portuguese of course. It puts the ‘I’ and ‘S’ in the porcine periphery acronym we’re not supposed to say. It’s Italian BTPs versus Spanish bonos.

And Italian government debt, or Buoni del Tesoro Polianuali, has had a tough time of it lately.

In fact, according to Citigroup, it may be having a tougher time of eurozone contagion than Spain:

Since the beginning of the year (until recently) BTP and Bono yields have occupied a very narrow range. Bonos tended to outperform in rallies and underperform in selloffs. It is telling in the most recent sell-off that is has been BTPs that have underperformed for the first time. It is worrying for Italy, and possibly reflective of a combination of positioning and faltering domestic appetite, that recent weeks have seen BTPs, not Bonos, underperform in sell-offs, and were unable to keep pace in the preceding rally. Tier 2 spreads have tended to move together (Figure 6), but it seems that this correlation may be breaking down.

The domestic appetite is the thing to focus on here, since, as we’ve noted before, Italian banks have tended to be big, big buyers of BTPs. It has been a fairly easy carry trade — using easy money from the European Central Bank to snap up higher-yielding debt from their own sovereigns, for a profit.

And on that note, Citi’s Robert Crossley has some interesting data:

One factor which may help explain a possible change in domestics’ appetite for BTPs is the change in carry dynamics. Figure 8 shows the changes in 3-month carry for 2, 5, 10 and 30yr BTPs, adjusted for volatility. The sharp decline in risk-adjusted carry at the 2 and 5yr points in recent weeks is striking. If we look instead at 1-month carry, adjusted for 1-month realized volatility (Figure 9) we see a more pronounced fall, again led by the front end as you would expect, but with the carry decline more evenly spread across tenors.

Whichever way you slice it, Citi says, risk-adjusted carry has fallen, making Italian debt less attractive to Italian banks, and perhaps denting what has been a sizable buyer base. It’s not so much that Citi are worried about Italian banks actually selling-off BTPs (that would mean accounting losses), it’s just that falling domestic support for the debt will mean international buyers having to step in at a very delicate time.

Here’s Citi again:

… it is difficult to say whether higher yields would force domestic holders to sell some holdings of BTPs, as the risk of further losses looms and risk limits are stretched. What does seem to be clear though is that domestic support is falling. And that could be very significant in the current environment. If domestics have been the marginal support for BTPs, but are now getting tired, then international accounts will increasingly become the marginal driver. If so, then continued turmoil in the illiquid periphery will only drive the yields of the relatively liquid Tier 2 countries higher.

This round to the bonos.

Related links:
When Italy is already priced to wreck the eurozone - FT Alphaville
Italy will be eurozone’s biggest test, says Altman Z-score creator - FT Alphaville
Wake up and smell the BTPs - FT Alphaville

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