Italy’s sovereign credit rating in review: increased credit risk - ABN

Nick Kounis, head of financial markets research at ABN AMRO explained that in the coming months, a number of rating agencies will review Italy’s sovereign credit rating. 

Key Quotes:

"The main details of the current ratings, alongside the most recent and upcoming reviews, are set out below. Although only Moody’s currently has Italy on review for a possible downgrade, we think there is a high risk that Fitch and S&P also downgrade their ratings in the upcoming reviews. All three agencies point to the increased credit risk associated with potential fiscal loosening, and this risk may crystallise as the plans in Italy’s budget take shape. The commentary of DBRS suggests that the hurdle for a downgrade by that agency might be higher. It notes (rather generously in our view) that ‘expected deviations from current fiscal targets due to the new political agenda are unlikely to weaken significantly public debt sustainability’."

So what would ratings downgrades mean for the Italian government bond market? 

"Downgrades could hurt market sentiment, but what we think really matters is the likelihood that Italian’s rating drops to non-investment grade. Such a scenario could make Italian government bonds ineligible for the ECB’s PSPP. Although net purchases are ending, if Italy had a sub-investment grade rating, it could stop re-investments of Italian public sector securities, skewing the proceeds of maturing Italian bonds to other jurisdictions. In addition, foreign official institutions have sharply built up their holdings over the last three years. Typically foreign exchange reserves are held in investment-grade securities and therefore a downgrade to junk could lead them to wind down their holdings. A downgrade would likely impact private sector foreign asset managers and bank investment policy as well. In short, if Italy loses its investment-grade status, it would be a major market event, which would lead to significantly higher spreads."

"So the real question rests on the possibility that Italy is downgraded to junk status. That looks unlikely in the short term. As shown in the table below, the current ratings are at least two notches above junk status. Rating agencies move slowly, and a move of more than one notch is not very common. In addition, for the ECB, all four rating agencies would need to downgrade Italy to a sub-investment grade rating, as it takes the best of the four. DBRS has the rating three notches above and the next review is not until next year (the exact date is not yet published). Beyond the ECB, the rules for other investors are a little less generous. Some reserve managers have a second-best rating rule based on S&P, Fitch and Moody’s, but that still would require a lot of downgrades. Another mitigating factor relates to the structure of Italian bond holdings. Foreign holdings are at historically low levels. Furthermore, Italian banks have shown their willingness recently to once again buy aggressively during market sell-offs."

"Overall then, the buffer to investment-grade provides some short-term protection for the Italian government bond market in terms of the risks related to ratings downgrades. Nevertheless, we continue to see downside risk to Italian government bonds given the likely deterioration in the fiscal outlook in the coming months."