By Dhara Ranasinghe
LONDON (Reuters) - A coronavirus outbreak that may tip Italy into recession also threatens hefty losses for fund managers who have been overlooking a multitude of risks to invest in one of the few euro zone bond markets offering yields above zero.
For weeks, even with the coronavirus flare-up in China fuelling concerns about global growth, investors flocked to higher-yielding southern European debt -- attractive at a time when almost 70% of all euro zone government bonds yield less than 0%, according to Rabobank.
Roughly half of positive-yielding euro area debt is from Italy, so no surprise that Italian 10-year bond yields tumbled 50 basis points in January as the buyers rushed in.
That trend has now stalled. As Italy grapples with the worst outbreak of the virus in Europe, investors - for now at least - have woken up to the country risks they previously set aside.
Italy's 10-year borrowing costs have risen to a one-month high at 1.09% (IT10YT=RR), pushing the yield premium over top-rated German Bunds (DE10YT=RR) to 161 bps.
That spread, a closely-tracked measure of relative risks, has widened almost 30 bps this week, set for its biggest weekly jump in over six months.
Italian stocks have tumbled more than 5% this week .
(Graphic: Italian/German 10-year bond yield spread, weekly change - https://fingfx.thomsonreuters.com/gfx/mkt/13/2549/2517/IT2602.png)
"What this week's bond selloff in Italy shows is that the yield pick-up story is not supreme," said Wouter Sturkenboom, chief investment strategist for EMEA and APAC at Northern Trust (NASDAQ:NTRS) Asset Management.
Credit default swaps (CDS), reflecting the cost of insuring exposure to Italian risk, are at four-week highs and Italian bank CDS have also jumped.
Yields on safe-haven Bunds have tumbled (DE10YT=RR).
The coronavirus hit is hurting one of the euro zone's most vulnerable members -- with public debt totaling over 130% of gross domestic product, an economy that is barely growing and almost constant political infighting.
Earlier this month, Bank of Italy Governor Ignazio Visco flagged Rome's higher risk premiums versus Spain or Portugal, warning about the "chronic vulnerability" of public finances.
Now as the economy reels from measures taken to contain the virus outbreak, the debt trajectory will likely worsen.
The selloff could catch out swathes of investors who had expected the risk premium to gradually shrink.
Goldman Sachs (NYSE:GS) for instance told clients last month the Italy/Germany yield spread could tighten to 120 bps, levels last seen in May 2018 -- before a political crisis erupted.
(Graphic: Italian/German spread, Italian 5-year CDS - https://fingfx.thomsonreuters.com/gfx/mkt/13/2552/2520/IT2602dr.png)
Investors also flocked to Italy's sale of 15-year bonds earlier this month, putting in more than 50 billion euros ($55 billion) in orders. That topped even the record demand for an Italian 30-year bond in January.
David Zahn, head of European fixed income at Franklin Templeton, continues to hold Italian debt in the funds he manages and expects them to add value to the portfolios.
Italian bond holders encompass a range of investors -- latest data from EMAXX shows one sovereign issue maturing March 2020 was held by funds run by the likes of BNP Paribas (PA:BNPP), Invesco, Generali (MI:GASI), Deka and Amundi.
"The flow of late...has been very strong into (Italian) BTPs," said Tim Graf, chief macro strategist at State Street (NYSE:STT) Global Markets. "I suspect it is as much a reversal of recent momentum as it is a significant repricing."
Other southern European bonds, also in high demand in recent weeks, have come under pressure too.
Greek 10-year bond yields, up 23 bps this week (GR10YT=RR), are heading for their biggest weekly jump since October 2018. Spanish and Portuguese yield spreads over Germany are at their widest since September.
There are many who are prepared to look past the outbreak as the European Central Bank's backstop remains in place; money markets are pricing rate cuts again.
While 15-year Italian bonds, for instance, have shed almost 3% of their value in price terms in the past two weeks, they are still up almost 5% from where they traded a month ago. Equivalent German bonds have gained almost 2% in the last two weeks.
Some argue that the temptation to move back into positive yielding peripheral bonds may prove too strong to resist.
"Monetary stimulus will bring relief and recovery, enabling capital to continue to chase carry," said Mondher Bettaieb-Loriot, a senior portfolio manager at Vontobel Asset Management.
(Graphic: Negative yielding government bonds, heatmap - https://fingfx.thomsonreuters.com/gfx/mkt/13/2553/2521/NEGyields2602.png)