Italian government bonds are peripheral European investments and trade as such – they have embedded risk and are correlated to credit risk over the long term.
But this relationship has broken down over the last few months. The following graph tracks the Italian spread to German bunds against investment grade credit (as measured by iTraxx Main) over the last 12 months.
Italian spreads have widened significantly, reflecting a much weaker performance from Italy than corporate bonds. Italy has been hampered by the rise in political uncertainty across Europe, yet credit risk assets have carried on unburdened.
So is Italy overreacting, or is credit complacent?
We think the latter.
Political risks in Europe are not currently priced in to credit markets, across investment grade and high yield. While we have a relatively sanguine view on the most likely outcomes for Europe, the Brexit referendum vote has put previously inconceivable ideas into the future political landscape – and complacency is not recommended.
Certainly a cheapening of Italian bonds is a welcome move – while the country’s December referendum caused little stir, investors are realising that elections outside its borders in 2017 could intensify its existing economic problems.
We expect this to translate into a credit market wobble at some point this year as uncertainty about the strength and implications of rising populism hurts sentiment. In our view this will be a buying opportunity – overall we expect credit to perform relatively well in 2017, thanks to an improving macroeconomic backdrop and continued policy support.