Italian Bond Yields Skyrocket

Italian Bond Yields Skyrocket

Investors began to abandon Italian bonds in droves last week as fears intensified that Italy would be the next Eurozone country to experience a debt crisis. As I wrote last week, Italy has a national debt of €1.9 trillion ($2.6 trillion) compared to Greece’s €355 billion. Italy has the eighth largest economy in the world based on GDP and the fourth largest in Europe. Its annual GDP was just over $2 trillion in 2010.

Yields on 10-year Italian bonds soared to 7.4% in late trading in Rome today, a high for the euro era, in the latest sign that investors are fast losing faith in the world’s third-largest sovereign-bond market. Yields might have risen even higher in the past week but for heavy bond buying by the European Central Bank. Another reason for the jump in Italian bond yields is that international clearing house LCH.Clearnet raised margin calls on Italian bonds, making them more expensive to trade.

With the cost of Italian debt soaring, the euro is plummeting and the large-scale debt crisis that we have all been fearing appears to be unfolding before our eyes. At rates of 7-8%, more investors may decide to head for the exits, and Italy could find itself unable to raise sufficient money in the bond markets.

Given the sheer size of Italy’s debt, it may require huge international assistance. The funds potentially available to Italy from Europe and the International Monetary Fund are unlikely to meet Italy’s needs, however. Failure to halt the crisis could lead, in the worst case, to an Italian debt default that cripples Europe’s banks, plunges the region into a slump and roils the global financial system.

Investors Losing Confidence in Italian Debt

With Italian bond yields surging higher, analysts say Italy is at the brink of being unable to afford to borrow in the public markets. Italy has long relied on the fact that its debt level, although high at 120% of GDP, isn’t rising much thanks to Rome’s relatively small budget deficit. But the country still needs to borrow hundreds of billions of euros a year to repay its debts coming due.

Next year, Italy must borrow enough money to repay more than €300 billion in maturing debts and cover a targeted budget deficit of up to €25 billion. If investors aren’t willing to lend Italy such sums, Europe will have to prop up the country with all the money it can muster—with help from the IMF – or risk a global financial crash.

A failure by Italy to honor its debts on time is currently considered a remote prospect, precisely because its impact on Europe’s banking system and other government bond markets would be so disastrous. But it is certainly not as remote a possibility as just a few months ago. European policy makers are scrambling to draw up contingency plans (ie – a bailout) in case Italy can’t attract enough private capital.

So far, Italy has been able to attract buyers for its debt, albeit at rising costs. When Italy launched a new 10-year bond in August, it paid buyers a yield of 5.22%. When it sold more of the same bond in October, the yield demanded was 6.06%. Today it went to 7.4%.

A short-term spike in borrowing costs is a manageable problem for Italy, since only a small part of its debts need to be refinanced at a given time. The problem isn’t necessarily higher yields, but investors’ appetite for holding Italian debt at all. Many investors now fear that Italian bonds will lose further value, inflicting losses on them. This could leave the government with too few buyers of new bonds.

According to the Italian Treasury website, Italy has almost €59 billion in total maturing debt in November and December, some of which has already been rolled over during the last two weeks. The Treasury estimates that it will have to sell apprx. €325.8 billion in various debt over the next 12 months ending in October 2012.

Most importantly, the Italian Treasury has reportedly decided to go ahead with an auction of $5 billion in T-bills tomorrow. With yields on 10-year bonds surging to 7.4% today, it will be critical to see what yields do tomorrow. If Italian yields continue to rise, expect to see some very ugly markets tomorrow morning!

I’ll keep you posted with additional blog posts as needed in the next few days.