Italian and Spanish spreads: Further to fall?

Following a 2013 that saw euro area peripheral government bond spreads fall dramatically, 2014 has seen further reductions in funding costs. Spanish and Italian 10Y spreads to Bunds are now around 200bps, having ended 2013 around 20bps above that level. That compares very favourably to the start of 2013, when Italian spreads were almost 320bps, while Spanish spreads were close to 400bps. And demand for paper is very high - today’s sale of Spanish 10Y bonds has attracted around €40bn of orders, while both Ireland and Portugal very successfully tapped bond markets earlier in January, drawing enormous demand for their bond issues. Importantly given the extent to which ECB-funded domestic banks supported the markets over past quarters, demand from overseas has been very strong – 83% of the Irish bond sale went to foreigners, and a mammoth 88% of the Portuguese. And to top off a good start to the year, Ireland’s upgrade from Moody’s at the end of last week to investment grade provided a further boost to that country’s bond markets, with 5Y yields falling below their US equivalents earlier this week.

So, having made so much progress over the past year or so, is there any value left in peripheral government bonds? Well, in a world in which the risks of euro break up and default have almost entirely disappeared, thanks to the backstop provided by the ECB’s OMT programme, and with brightening economic outlooks across the periphery, further spread tightening does seem likely, particularly in Spain and, perhaps to a lesser degree, Italy.

Of course, judging what is the appropriate spread level is in the post-crisis world is impossible. But one way is to look at where government yields are relative to other similarly-rated entities. The charts below (and here) plot Spanish and Italian government bond yields relative to similarly-rated corporates (or corporate indices). Pre-crisis, government bond yields were (understandably) well below corporate bond yields. In 2010, the average yield of Spanish 7-10Y government bonds was 130bps below that of the yield for the iboxx corporate BBB 7-10Y € index (of course, at that time, Spain was rated far above its current levels). For Italy the equivalent figure was 160bps. But in 2012 and 2013, the roles were reversed, with government bond yields rising well above corporate bond yields. Only now have yields fallen back to those of corporate bonds.

And a return to the pre-crisis position, where corporates (rightly) paid a significant risk premium over governments, seems on the cards. Investors no longer fear mass euro break up, thanks to the OMT programme and the existence of the ESM. Equally, improved growth prospects, in Spain in particular, have altered investor perceptions about the sustainability of fiscal positions, with Ireland’s surprisingly large upgrade last week adding to hopes of upgrades for other countries in the periphery. Expect, therefore, both Italian and Spanish spreads to Germany to tighten further from here through the remainder of this year, with Spanish spreads likely to outperform Italian spreads given that country’s relatively better growth and fiscal positions.  And while a return to the single-digit spreads that prevailed before the crisis seems inconceivable – the crisis amply demonstrated that not all country risk in the euro area is the same as that for Germany – a move to double-digit spreads is not inconceivable, in particular for Spain.  

Italy: Government and euro corporate bond yields

Ital gov 220114gl

Source: Bloomberg, Datastream and Daiwa Capital Markets Europe Ltd.

Spain: Government and euro corporate bond yields

spain gov 220114gl

Source: Bloomberg, Datastream and Daiwa Capital Markets Europe Ltd.


Grant Lewis, Head of Research

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