After S&P downgrades Italy's rating, it goes up the risk of a similar move on Spain, which would lose its Investment Grade status. Analyzing a single category of investors with portfolios linked to benchmarks, the European investment funds, it can be estimated that a possible loss of IG status could generate forced disinvestments by the Bonos for an amount of 31 billion from the Bonos (5,2 % of the Bonos stock) and by BTPs for 58 billion euro (4,2% of the BTP stock).
A series of events, mostly political, put European financial markets under pressure. After the government crisis in Portugal and the tensions in Greece over the disbursement of the new tranches of the EU loan, the scandal involving the Spanish Prime Minister Rajoy and the downgrade of Italy by S&P have generated a new widening of spreads against Germany and a flattening of the peripheral curves.
Let's make some considerations regarding the effect of a possible downgrade for the two potentially more countries destabilizing for the euro area, Italy and Spain. The highest risk factor in the short term is that after Italy's downgrade of one notch to BBB from BBB+, S&P also downgrades Spain's rating, which is only one notch below investment grade. As we wrote earlier the loss of IG status could have a big impact on Spanish debt and trigger a contagion effect on other peripherals. The share of Spanish debt held abroad, net of securities bought under the SMP and held by the ECB, after having increased from a minimum of 23% in August 2012 to 30% in January '13, returned to a decrease and at the end May is estimated to be equal to 26% of total non-stripped securities (174 billion euro).
The data relating to the holding of Italian government securities, again purged from the ECB portfolio, are available with greater delay and in any case show a similar trend to that of Spain, with an increase in the share held by foreigners in the first months of 2013, which .29,5% in October '12 to 30,6% in March '13 (622 billion euro). It is difficult to accurately predict the effect on the share of debt held abroad of a deterioration in the rating of the two countries because portfolio choices respond to multiple logics, however it is possible to make estimates of the impact of a deterioration in the rating to sub IG on that part of portfolios that are typically linked to a benchmark, such as investment funds.
According to ECB data, the stock of bonds held by European investment funds, typically benchmark investors, amounts to 3.068 billion euro (out of total assets of 7,6 trillion euro), of which 25% is represented by government bonds of euro area countries (amounting to 753 billion euro). We use as a reference the composition of government indices from Bloomberg where Spain has a weight of 11,2% in the Sovereign Euro index and 3,04% in the Global Developed Sovereign index and Italy has a weight of 22,2, 5,99% on the euro index and XNUMX% on the world index.
Assuming that the portfolios of European funds are neutral on benchmarks and using for simplicity the average of the weight of the two countries on the two types of indices, it can be deduced that a possible loss of IG status could generate forced disinvestments for an amount of 55 billion from Bonos (10% of the Bonos stock) and 106 billion euros from BTPs (8,2% of the BTP stock). If we exclude from the calculation the domestic investment funds of the two countries, which in order to avoid sales would probably be induced to relax their portfolio constraints, the expected outflows are significantly reduced, to 58 billion for Italy and 31 billion for the Spain. To understand the extent of outflows of this size, we recall that the ECB purchased through the SMP at the end of 2011 approximately 103 billion BTPs and 45 billion Bonos.
The effect on yields of a sub-IG downgrade of Italy and Spain would be disruptive for the market. The simple relationship between yields and rating tells us that at current prices the BTP-Bund spread is overvalued by 10bps and the Bonos-Bund spread is overvalued by 30bps. A worsening of Spain's rating to sub-IG level for two of the rating agencies could translate, on the basis of this mere static relationship, into a widening of the spread on the 10-year Bund by around 85bps from its current level, while for the Italy the widening of the spread consistent with a one notch cut by all three agencies would be 60bp, while a two notch cut would imply a widening of the spread to 10 years against the Bund to 410bp. These values can obviously only serve as a reference and cannot be read as estimates of the level of the spreads as they do not take into account either a dynamic effect of contagion among all the euro countries which would shift the relationship between spread and rating upwards, nor on the other hand, the existence of an EU/ECB backstop mechanism which could have a calming impact on market dynamics, especially on short-term spreads, as already happened in the summer of last year with only the announcement of the OMT .
