By Yoruk Bahceli and Stefano Rebaudo
AMSTERDAM/MILAN (Reuters) - Italian government bonds seem resilient in the face of a political crisis as investors back the high-yielding debt, a contrast to sell-offs seen during past episodes of government instability.
Italy's government lost its majority last week after a junior coalition party pulled out of Prime Minister Giuseppe Conte's government, stripping his majority in the midst of the COVID-19 pandemic.
That led to Conte looking for outside backing, seeking to avoid yet another snap election. The news barely shook bond markets, with the gap between Italy and Germany's 10-year yields, the risk premium on Italian bonds, rising just 10 basis points.
In 2018, fears that a snap election would benefit eurosceptics gave Italian bonds their worst day in over 25 years. Prior political turmoil also threatened the future of the euro area.
"Certainly the biggest reason we haven't seen much of a reaction is that it's rather unlikely that we see a new election, and that is the only risk here," said BlueBay Asset Management portfolio manager Kaspar Hense.
That's as investors focus on a vote of confidence in the government on Monday and a tougher senate vote on Tuesday. A new government led by current Prime Minister Giuseppe Conte seems to be the most likely result.
With the turmoil pushing Rome's bond yields up from record lows, investors see it as a new opportunity to buy one of the only governments in the euro area that still offers meaningful yield. UniCredit expects the risk premium, currently at around 114 bps, to hover around 125-130 bps until it becomes clear new elections won't be necessary.
Hense sold some of his holdings in Italian sovereign bonds but is looking to re-enter at a spread of 120 bps in the coming days.
Graphic: yield spread: https://fingfx.thomsonreuters.com/gfx/mkt/azgvolrgnpd/Pasted%20image%201610975034224.png
For now, banks and investors have mostly ruled out snap elections. Even if one takes place, investors are less worried about the risks associated with the far-right League's potential victory than they used to be.
They expect the party to be less eurosceptic than previously given the support Italy gets from the European Union's coronavirus recovery funds, alongside bond buying from the European Central Bank, which keeps a lid on Rome's borrowing costs through its pandemic emergency bond purchases (PEPP).
"The idea of an Italian (EU) exit at this stage seems so far away and not in anyone's interest to have that conversation," said Gareth Hill, fund manager at Royal London Asset Management, who briefly increased his holdings last week.
Forecasts of how much Italy's risk premium would rise in the event of an election range wide: Credit Suisse expects a jump to 150 bps while UBS sees a likelihood of 200 bps, with the ECB unlikely to use its full firepower to cap yields.
"It's true the central bank (ECB) is flexible in increasing, decreasing or changing the distribution of the funds, but this is just to address issues related to the pandemic," UBS strategist Rohan Khanna said, referring to PEPP.
Should the risk premium rise that high without a resurgence in euroscepticism, investors like Royal London's Hill expect to increase their holdings further.
(Reporting by Yoruk Bahceli in Amsterdam and Stefano Rebaudo in Milan; editing by Thyagaraju Adinarayan, Larry King)