By Dan McCrum in New York
US hedge funds are placing large bets against the value of Italian government debt, directly shorting the bonds of the eurozone?s third largest economy.
The funds have increased the size of short positions in the past month, speculating that investor concerns over the country?s ability to fund itself may spread from Europe?s periphery to Italy, according to investors in the funds briefed on the strategy.
On Friday, yields on Italian government debt – the largest bond market in Europe – hit their highest levels since October 2002. Italy is now borrowing at its biggest premium over German Bunds, the benchmark for the region.
The move followed the surfacing last week of tensions between Silvio Berlusconi, prime minister, and Giulio Tremonti, Italy?s finance minister, over the country?s proposed austerity programme.
As Italy?s funding costs rise, the value of its existing debt falls, creating a profit for those who have shorted it by borrowing the debt to sell and buy back at a later date.
The funds are using the strategy in preference to buying credit default swaps, as attempts by the European authorities to avoid a technical default that would trigger CDS pay-outs for Greece have raised ques-tions about the effectiveness of such derivative instruments.
Directly shorting government debt was typically considered riskier than buying default insurance, as a short-seller must locate specific securities to complete the trade. The Italian bond market is highly liquid, however, and before the financial crisis shorting Italian bonds was a common strategy.
The trade is based in part on expectations for the demand from Italian institutions – owners of most of Italy?s sovereign debt – which diminishes as the financial year progresses.
Meanwhile, the Italian government still has more than half its 2011 total debt issuance to go, a greater amount at this stage of the year than normal. Italy has a budget deficit below zero, but the country must refinance 900bn euros ($1,280bn) of maturing debt over the next five years.
?A combination of fundamental and technical reasons . . . mean Italy has probably got yields going up to some degree,? says Gary Jenkins, head of fixed income research at Evolution Securities.
?Ironically, the trigger point for the trade to go wrong could be when it is at its most profitable. If the Italian situation gets too bad, then European governments would have to step in and do something,? he adds.
If Italy?s economy were to suffer a debt crisis, he says, the final policy option available will be common eurozone debt issuance funded by the member countries.
? The Financial Times Limited 2011