Is the spread risk back?

We are talking, for those who are not yet familiar with it, about the spread (which in English is called the spread) between the yields of Italian government bonds and German government bonds (Bunds) of the same maturity. Specifically, the yields of 10-year maturity Polyannual Treasury Bonds (Btp) and German Bunds that have the same residual life are taken as a reference.

In recent weeks, as international stock exchanges underwent a significant correction, the Btp/Bund spread resolutely embarked on an upward trend, recently surpassing the 230 basis point threshold (2.3 percent).

It has been about two years since we have seen such high levels, that is, since the international economy was challenged by the Covid-19 health emergency. But why is the Btp/Bund spread so important?

In the international business community, the yield differential between German government bonds and those of other countries that are less financially sound than Germany (e.g., Italy) is considered a kind of barometer for measuring turbulence.

When there are phases of instability in the markets, the spread goes up. Conversely, when some calm returns to the financial markets, the spread goes down. This is because, during periods of instability, international investors try to reduce the risk component in their portfolios and increase exposure to securities considered safer such as German Bunds.

In the wake of increased demand, the prices of Germany's government bonds go up while their effective yields collected by the investor go down (as those who buy them pay a higher price to have a certain amount of interest guaranteed by these same bonds).

Conversely, again when there is turmoil, many international investors reduce the component invested in government bonds such as Italian Treasury Bonds in their portfolios (since our country has much higher debt than Germany and is less easy to finance in the market). And so, on the back of lower market demand, the prices of Btp bonds go down while their effective yields collected by the investor go up (as those who buy them pay a lower price to get a given coupon, that is, a given amount of interest).

Thus, this explains why the Btp/Bund spread has widened in recent days. In fact, on June 9, the president of the European Central Bank (ECB), Christine Lagarde, announced a double news: first, there will be a change of course in monetary policy starting in July.

Interest rates in Europe will be raised starting next month, with an initial upward adjustment of a quarter percentage point (0.25 percent), to be followed by another in September, the size of which has yet to be determined.

The other news announced by Lagarde is the end from July of Quantitative Easing, that is, the program of purchases of European government bonds carried out in recent years by the ECB itself at the behest of former President Mario Draghi, which at the time succeeded in stopping speculation in the market and bringing much stability to the Old Continent's financial system.

With the prospect of an imminent end to Quantitative Easing, investors in recent days have behaved as described above: they have begun to fear a new phase of turbulence in the Eurozone and have therefore positioned themselves on government bonds that are considered safer, such as precisely Bunds, while lightening their positions on the riskier BTPs.

But what are the consequences of spread growth on the public accounts of a highly indebted country like ours?

If the yield on BTPs rises, of course, the Italian state must pay more interest when it issues new Treasury bonds in the market to finance itself and to cover its deficit.

Economist Carlo Cottarelli, director of the Observatory on Italian Public Accounts at the Catholic University (who previously served as the government's Commissioner for Spending Review and has worked for the International Monetary Fund), has calculated the increased burden on the state from a one-percentage-point increase in interest on the debt at three billion euros in one year.

So this is not a very large figure when compared to total Italian public spending. However, there is cause for concern for Cottarelli if the spread increase proceeds more rapidly than expected in the coming weeks.

Angelo Baglioni, a professor of Political Economy at the Cattolica University, hopes for a little more clarity on the tools the ECB will use in the future to stabilize the market in the absence of Quantitative Easing. On this point, the Cattolica economist believes Lagarde has not given comprehensive explanations. "Such vague announcements are not good for the credibility of the central bank, and the collapse of stock markets that occurred on the day of the announcement, along with the widening of spreads, proves this," Baglioni argues.

Of course, an increase in spreads and a return of volatility in bond and government bond prices always has consequences for investors' portfolios.

The turmoil of past years, such as that of 2011-2012 when there were fears of a Eurozone breakup, have highlighted some important aspects.

First, it is essential to be able to approach these phases with a well-diversified portfolio, built with the help of a financial advisor. This is the only way to best dose risk exposure by allocating the portfolio among different asset classes.

In addition, a good advisor is able to help the investor look ahead and know how to wait, without taking hasty steps.

Although the spread has already widened in recent weeks, it should not be forgotten that inflation is expected to remain high in the coming months prompting central banks to raise rates further. That is why in the fixed income sector it is best to tread cautiously.