With France and Germany's high-stakes elections out of the way, investors are gearing up for perhaps Europe's most important vote -- Italy's.
For some money managers, the threat of a populist upset in the eurozone's most debt-laden and slowest-growing major economy is a greater risk than any other election in this poll-packed year.
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But that risk, in part, means that Italian government debt offers higher returns than its peers, presenting an attractive bet for some investors.
Italy's parliamentary elections must be conducted no later than May 2018 and some senior Italian law makers see it happening just before then.
"Italian politics is a byword for uncertainty, and that's particularly true if you look at the parties involved this time and their policies," said Charlie Diebel, head of developed market rates at Aviva Investors, an asset management firm. "The potential havoc it can wreak has always made it the biggest of the three elections."
In recent years global investors have shied away from Italy. Nonresidents currently own around 32% of Italy's outstanding government bonds, down from 44% in the summer of 2010, before the worst of Europe's sovereign debt crisis unfolded. That compares to 48% for Germany, and 52% for France.
Investors see many problems. Italy's public debt level is now nearly 135% of its GDP, compared with a regional average of just below 90%. Local banks still haven't really opened their wallets, with a mountain of bad debts still to be resolved.
Then there is the politics.
Opinion polls currently put the populist 5 Star Movement, which has proposed a referendum on Italy's euro membership as a last resort if Rome cannot win fiscal concessions from the rest of the European Union, roughly tying with the governing center-left Democratic Party. The idea that populist movements in countries such as Italy, France or the Netherlands can gain power and take their countries out of the eurozone has spooked investors.
In Italy, support for the euro is already low. A poll released by the European Commission on support for the currency union in May found 58% of Italians favored the common currency, the lowest proportion of any eurozone nation.
But none of this has stopped some investors dipping back into Italian government bonds, as they hunt for yield amid a collapse in returns on everything from the safest German bunds to European junk debt.
The Bank of America Merrill Lynch euro high yield index, covering corporate bonds rated below BBB, currently offers an annual return of 2.3% -- barely above the 2.1% offered by 10-year Italian bonds.
"Italy just looks cheap next to other investment grade credit," said Myles Bradshaw, head of global aggregate fixed income at asset manager Amundi, who is overweight on Italy, Spain and Portugal. "The economy is turning round, and it's got potential."
Though Italy's economic growth is slower than many of its neighbors, GDP picked up to 1.5% year-over-year during the second quarter, its fastest pace in six years.
Andrea Iannelli, fixed income investment director at Fidelity International, said that on a relative value basis Italian government bonds offer value.
"They're one of the most liquid government bond markets in Europe," he said, pointing out that a deep futures market would allow him to hedge risks if volatility does rise.
Mario Draghi's 2012 promise that he would do "whatever it takes" to save the euro sent bonds from Europe's economically troubled periphery trading higher since then.
But Italian bonds have lagged behind, providing more ballast to the opinion that they are relatively cheap.
During that period, Italian 10-year spreads have declined by 3.1 percentage points against 10-year German bunds, compared with a decline of 4.4 percentage points for Spain and 7.7 percentage points for Portugal. Spreads rise when prices fall.
Italian government bonds now yield more than their Spanish peers, a reversal of the trend during the euro crisis.
Politics isn't the only factor that is made investors more cautious about Italian government debt. As the eurozone's economic growth picks up speed, expectations have risen that the European Central Bank will begin to slow down its bond-buying program. The countries with lagging economies have benefited most by this support, investors say, and so will be hit hardest when it declines. Italian growth has been the biggest laggard.
Spain's economy surpassed its precrisis peak this year, but Italy's is still some distance from its peak size in 2008. In fact, Italy has only grown by a cumulative 7.2% since the inception of the euro in 1999. In comparison, Spain has grown by 40.3%.
Still, the average interest rate Italy is paying for its debt is an all-time low of 3%, and the maturities on that debt have been gradually extended, meaning they won't be forced to pay it back in any hurry, according to Nomura European rates strategist Ioannis Sokos.
Rather, "political uncertainty and not ECB tapering to be the main threat to Italy's debt sustainability over the coming years," he said in a research note.
Write to Mike Bird at Mike.Bird@wsj.com
(END) Dow Jones Newswires
September 28, 2017 05:45 ET (09:45 GMT)