Analysis-'Magic moment' for Italian bonds as foreign interest revives

By Sara Rossi and Gavin Jones

MILAN (Reuters) - International investors look poised to reverse a decade of disinvestment from Italian government bonds, as high yields and encouraging economic reports spur demand for the debt, latest data shows and analysts say.

A vote of confidence in what has for years been seen as one of the riskiest euro zone bond markets would boost Rome's efforts to manage the bloc's second-largest debt pile, as the European Central Bank winds down its bond purchases.

Foreign holdings of Italian government paper increased in February after 10 consecutive monthly declines, according to Bank of Italy data.

Moreover, in April the value of Italian notes borrowed by investors betting on a fall in their prices had dropped by around 40% to $27 billion from a mid-November peak of $46 billion, S&P Global Market Intelligence data showed.

Analysts say firmer-than-expected economic growth, declining public debt, and the prospect of political stability under Giorgia Meloni's seven-month-old government are starting to lure foreign investors back to Italian bonds, demand for which proved resilient even as recent banking turmoil roiled world markets.

Domenico Siniscalco, vice chairman of Morgan Stanley and a former Italian economy minister, said Italy was no longer seen as a target of speculation, and international investors were now looking at the country with "total calm and confidence".

"This is a magic moment for Italian bonds," he told Reuters.

There is much lost ground to make up.

The share of Italian government debt held by foreign investors fell to below 20% at the end of 2022 from around 50% before the 2008 financial crisis, Bank of Italy data shows. The 2012 euro zone debt crisis and the COVID-19 pandemic triggered sharp sell-offs.

Luca Cazzulani, head of strategy research at UniCredit, said the level of yields now offered by Italian paper makes it hard for foreign banks and funds to ignore.

"Keeping an underweight position on Italy will risk hurting (investors') performance," he said.

The yield on Italy's 10-year BTP bonds has risen from a record low around 0.4% in February 2021 to about 4.2%, following the massive ECB rate hike cycle which began last July.

The 10-year yields are almost double those of higher-rated German peers and some 70 bps above benchmark U.S. yields.

POSITIVE GROWTH SURPRISES

Economic growth in Italy, traditionally the laggard of the euro zone, has consistently beaten expectations since the end of the COVID pandemic, with gross domestic product (GDP) expanding by 3.7% last year after 7.0% in 2021.

That kind of growth represents a post-pandemic rebound which analysts say is not sustainable, but the positive surprises continued in the first quarter when GDP rose 0.5% from the previous three months.

In April the Treasury hiked its forecast for the full year to 1.0% from 0.6%.

"We are already seeing a more positive attitude towards Italy from non-domestic investors," said Filippo Mormando, fixed income strategist at Spanish bank BBVA, referring to the take-up of Rome's most recent syndicated bond deal, and financial flows in the latest balance of payments data.

The new trend started in April, Mormando said, thanks to a investor perception that global central banks would hike rates less aggressively after U.S. banking turmoil, and to progress made by Italy in covering its funding needs.

Italy has already met its net financing requirements for this year, well ahead of Germany, France and Spain.

On the political front Meloni, who took office in October, has largely avoided confrontation with the European Union and committed to keeping the budget deficit and public debt on a declining path.

"Hedge funds that last year probably speculated against Italy after the elections, have closed their positions. Now we are waiting for real money investors to come back," said Luca Mezzomo, head of macroeconomic analysis at Intesa Sanpaolo.

A HELPING HAND

A fall in Italy's debt-to-GDP ratio to 144.6% last year, down by five percentage points from the year before and by 10 points from 2020 has also helped sentiment. Meloni has targeted a decline to 141.4% this year.

The downtrend has been helped by the surge in inflation, which increases revenues and nominal GDP, and therefore proportionally lowers the debt-to-GDP ratio.

The picture is not all rosy. The rise in ECB rates increases borrowing costs for companies as well as the state, and Rome is struggling to meet policy pledges to the European Commission in return for some 200 billion euros ($220.16 billion) of pandemic recovery funds through 2026.

The country has also fallen behind schedule in spending the EU transfers it has already received.

However, Morgan Stanley's Siniscalco said these difficulties were not enough to undermine a promising public finance trend or hurt investor confidence.

On Friday Fitch Ratings, which last month cut France's rating, confirmed Italy at BBB with a stable outlook, while hiking its forecast for Italian GDP growth this year to 1.2% from 0.5%, above the government's own estimate.

The Italian Treasury has already taken steps to shore up demand for its bonds as the ECB retreats, by boosting purchases among domestic households and companies.

Together, Italian families and firms now hold around 215 billion euros, or 9%, of Rome's debt, UniCredit's Cazzulani said, the highest level since mid-2015.

($1 = 0.9084 euros)

(editing by Emelia Sithole-Matarise)