Italy Bond Traders Aren’t Sitting and Waiting for the Next Storm

(Bloomberg) -- Three months after the political imbroglio around forming a populist government roiled Italian assets, bond investors are contemplating a fresh hurdle: its first budget, due next month.

The big risk is that the euroskeptic Five Star Movement-League coalition breaks the 3 percent deficit limit set under European Union rules, putting the country on a collision course with the bloc. That’s got traders hunting a variety of strategies, from selling bond futures to buying Euribor options, to guard against the kind of market meltdown seen at the end of May.

For hedge funds, “the big one is futures, and the other one is to repo the bond itself,” according to Jason Guthrie, the London-based head of capital markets for funds company WisdomTree Europe. “That’s the primary way people take short positions” on Italy’s bonds, said Guthrie, whose firm runs two short funds for BTPs that mostly attract smaller investors.

With relations between the populist administration and the EU continuing to sour, here are some of the trades favored by investors looking to hedge the threat of another Italian bond storm:

Sell BTPs

Selling Italian bond futures, otherwise known as BTPs, is probably the most direct approach and hence one of the most popular. The derivatives act as a proxy for risk and their relatively high liquidity offers easy entry and exit.

  • The latest sell-off in futures started after mid-July, following reports of budget tensions -- subsequently denied -- between Italy’s Deputy Prime Ministers Matteo Salvini and Luigi Di Maio and Finance Minister Giovanni Tria. Tria has promised to respect the deficit targets set for this year by the previous government.
Italy Bond Traders Aren’t Sitting and Waiting for the Next Storm
  • Since July 20, the number of outstanding futures contracts -- known as open interest -- surged by 22 percent to about 415,000. That reflects the “greater hedging needs in BTPs due to the high volatility that we have had in the past months,” said Antoine Bouvet, a strategist at Mizuho International Plc.

Euribor Options

Another way to hedge is via Euribor, or the euro interbank offered rate. That’s a key interest rate used to price trillions of dollars of European securities. By purchasing options to sell Euribor contracts that expire after the budget is due, investors stand to profit in the event of a slump in the underlying contracts.

Italy Bond Traders Aren’t Sitting and Waiting for the Next Storm
  • This is illustrated in the FRA-OIS spread, which is used to quantify interbank market stress. It removes the policy rate component from Euribor, and therefore gives a measure of counterparty credit risk. The spread somewhat tracks the movement of Italian 10-year yields.

Coupon Contrast

An alternative option is to target a widening of the yield spread between low- and high-coupon bonds in the country. Traders would effectively be betting against the latter, which would fall much more if the nation’s creditworthiness is called into question.

  • After a jump in May, this spread remains elevated, and has been grinding higher since the middle of last month.
Italy Bond Traders Aren’t Sitting and Waiting for the Next Storm
  • Last week, Moody’s Investors Service said it was extending a review of Italy’s ratings “pending greater clarity” on the country’s fiscal path and reform agenda, with a conclusion likely by the end of October. Fitch Ratings is scheduled to assess the nation this month.
  • Newspaper La Stampa reported that the Italian government may reach out to the European Central Bank about a possible new round of bond purchases to shield the nation’s public debt from financial speculation and threats of a rating downgrade, citing an unidentified official.
    • The Frankfurt-based central bank declined to comment on the report, while no one from the press office of Prime Minister Giuseppe Conte in Rome was immediately available.

The yield on Italy’s 10-year bond fell six basis points, the most in two weeks, as of 5 p.m. Wednesday in London.

Default Swaps

Last but not least, there’s the classic credit-default swap. Investors can insure against a bad outcome by purchasing CDS for the Italian sovereign notes they hold, and it appears they have been: contracts hit the highest since 2013 in May, and after a brief respite have been climbing again this month.

  • Traders have the choice of two CDS contracts, one which protects against re-denomination risk, and one which doesn’t. The spread between the two indicates the extent of concern about Italy ditching the euro for the lira -- probably the worst-case scenario in any fallout from the impending budget.
Italy Bond Traders Aren’t Sitting and Waiting for the Next Storm
  • Once again, the spread has recovered since a blow-out in May, but remains three times higher than before the populist government formed.

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