Play Italian Five-Year Bonds Versus German Bunds

 | Jul 05, 2017 | 8:00 AM EDT
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The eurozone looked like a basket case a year ago, but it now seems ready to lead the world. It even will have a chance to bask in the glory of a G20 summit that will be held in the German city of Hamburg later this week.

One of the main fears of investors -- that Italy would implode under the weight of its troubled banking sector -- has been pushed aside for now due to positive developments in the single currency area's third-largest economy as measured by nominal GDP.

The Italian government will inject 5.4 billion euros ($6.1 billion) into troubled bank Monte dei Paschi, essentially taking control of the world's oldest bank. It also rescued two banks in the Veneto region, Banco Popolare di Vicenza and Veneto Banca, by promising 17 billion euros in guarantees to prevent senior bondholders and depositors from taking a hit.

These actions will contribute to the clean-up of Italy's banking sector, where bad debts --also known as nonperforming loans (NPLs) -- weigh heavily on the economy by making it harder for companies and individuals to borrow money for investment or consumption.

If these measures are followed by others, the banking sector slowly can return to health. It looks like the winds blowing from the European Central Bank (ECB) are favorable, too. In an opinion piece released today, July 5, ECB Vice President Vítor Constâncio said it is crucial that a coordinated strategy to tackle NPLs in Europe is implemented.

National asset management companies that take on the bad debts already have been successful in reducing NPLs in some of the single currency area's countries. Constâncio called for clarifying how these asset management companies can be made compatible with European Union legislation.

There are controversies surrounding bank rescues in the eurozone because of rules forbidding state aid and also because the EU passed legislation in 2014 that largely prevents state bailouts of banks. A blueprint for national asset management companies in the eurozone "would save authorities time and money," the ECB vice president said.

All this bodes well for Italy's economy because it points to willingness on the part of the ECB to get involved in resolving the NPLs problem. Italian banks were recovering in the first half of the year, and this is a good sign for the country's economy.

On the political scene, the threat of early elections in Italy has subsided, with President Sergio Mattarella saying recently that the polls are likely to take place when due, sometime in the spring of next year.

Therefore, for investors in bonds it may make sense to take a look at Italian sovereign bonds, also known as Buoni del Tesoro Poliennali (BTP). Marc-Henri Thoumin, a fixed-income strategist at Societe Generale, said investors should consider going long five-year BTPs versus German Bunds over the summer.

In Thoumin's opinion, Germany is more exposed than non-core eurozone countries to bearish repricing in government bonds as central bankers increasingly talk about winding down asset purchases.

The spread between the Italian five-year sovereign bond and the German Bund is 104 basis points; that's the lowest level since November last year, but still high compared with 50 basis points in April 2016, according to data from FactSet. So, there is still plenty of room for that spread to tighten.

The risks to this trade are a general risk-off move, with investors retreating from risky assets in general, and political risk due to elections in Germany this September and in Italy next year.

But "neither seems to be a threat just now, and the Italian elections in particular are unlikely to weigh before September," Thoumin said.

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