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Italy’s Unloved Banks Move Closer to Credit-Market Redemption

Italy’s Unloved Banks Move Closer to Credit-Market Redemption

Investors who until recently saw Italy’s banks as potential triggers of the next global financial crisis are now betting on their recovery.

Bonds issued by the country’s largest lenders Intesa Sanpaolo SpA and UniCredit SpA, as well as smaller rivals such as Banco BPM SpA, have rallied as investors rewarded progress in overhauling their balance sheets. Where once they were widely regarded as overburdened with toxic debt left over from previous recessions, they’re now seen as a buying opportunity.

This shift to viable investment option from epicenter of instability shows up in credit-market fear gauges. The cost of insuring Intesa Sanpaolo and UniCredit’s debt against default has halved since March when Italy’s banks were at the heart of a financial rout triggered by the coronavirus pandemic.

Smaller lenders have staged similar rebounds with bonds issued by Banco BPM and Mediobanca SpA advancing 70% over the same period, according to data compiled by Bloomberg.

This is a promising sign for a banking system that spent years struggling under the biggest pile of non-performing loans in the region in an economy likely to contract 10% this year.

Read More: Italy’s Fragile Finances Are Back to Haunt Europe Banks Again (1)

Much of this can be attributed to efforts by the lenders themselves, under pressure from regulators to put their houses in order by reducing the amount of bad debt on their books. The banks, like their peers across the region, have also benefited from emergency measures introduced by Italy’s government, the European Union and European Central Bank to counter the pandemic.

Toxic Debt

Non-performing loans as a proportion of total debt at Italian banks fell to 6.7% in 2019, from 16.5% in 2014, according to the ECB, most of it sold to investors at a discount. Meanwhile a measure of how big capital cushions are in relation to banks’ exposure to risk, known as Common Equity Tier 1 ratios, almost doubled to 13.9% between 2007 and 2019, according to the Bank of Italy.

That, according to Pier Carlo Padoan, Italy’s finance minister from 2014 to 2018, has left lenders better able to face the fallout from the coronavirus and a renewed wave of debt going sour.

“The Italian banking industry is facing the Covid crisis in better shape than it was in the past, after years of restructuring allowed banks to cut non-performing loans and improve capital buffers,” he said in a phone interview. “They are now well equipped to face a new wave of NPLs.”

Italy’s Unloved Banks Move Closer to Credit-Market Redemption

Building those capital buffers is also getting easier, with investors charging less to hold the debt issued to fund them. When in January 2016 Intesa raised 1.25 billion euros ($1.48bn) selling Additional Tier-1 bonds, the riskiest form of bank debt, it paid a 7% coupon. When it sold AT1s again in February this year, the cost was 3.75%.

The investors that bought the earlier issue have also made money, as it’s rallied to trade through 5%, outperforming the wider AT1 sector, according to data compiled by Bloomberg.

Similarly, Banca Monte dei Paschi di Siena SpA, the world’s oldest bank, priced a 750 million euro five-year senior bond at 285bps over the midswaps benchmark in January, over 150bps inside where it priced a shorter three-year note in July 2019.

Falling Risk

Italian banks were still out of favor at the start of 2017, their AT1 bonds traded at an average yield of 8.3%. Now the notes are quoted at about 6.2% on average, more in line with peers.

Luke Hickmore, investment director at Aberdeen Standard Investments, said Italian bank debt remains one of his larger exposures at about 6%, up from zero 18 months ago.

A resurgence of Italian political risk may prompt him to pare his holdings, he said. Weakness in government bonds affects bank debt because Italian lenders hold more than 440 billion euros of the country’s bonds.

For now, that’s not a major worry. Helped by EU stimulus programs, Italy’s debt has rallied, driving the yield premium for 10-year bonds over their German equivalent, a barometer of risk in the region, close to its tightest since February.

Read more: What $4.8 Trillion of Euro-Area Support Is Doing to Risk Gauges

Italian banks are also due for consolidation, given the country is home to almost 500 different lenders, and bigger lenders may mean a more stable industry. Intesa’s recent takeover of smaller rival Unione di Banche Italiane SpA could set the tone for what’s to come for the entire sector, according to James MacDonald, a senior credit analyst and portfolio manager at BlueBay Asset Management LLP.

“It’s a weak banking sector, but notwithstanding that, there are still some very good banks in Italy,” MacDonald said.

©2020 Bloomberg L.P.