Traditionally loved by Italian savers, BTPs have enjoyed excellent performance over the past five years. Let's analyze whether today there are still reasons to invest in these bonds.
Is it still worth investing in BTP nowadays?
It's been a while since this blog has taken stock of Italian government bonds. I thought it was appropriate to "remedy", both for the importance (in general) of bonds in defining a well-diversified portfolio, and for the Italian political situation, which is becoming more and more - in its own way - "interesting".
Also because, if we look at the last five years, investing in the most classic of Italian government bonds, BTPs, has made good business, as shown by the real performance graph (i.e. the total return adjusted to take into account the erosive effect inflation) of Italian government bonds.
But, you know, the past is the past. So let's look forward to the future. Focusing on nominal BTPs (those indexed to inflation we will address them another time).
Why invest in BTPs
If you are a saver with something to invest, in short, there are two main reasons for buying bonds of this type:
the yield to maturity, which is obtained by holding the security for its entire residual life (i.e. acting as a "cash-keeper"), collecting and possibly reinvesting the coupons and any positive difference between the redemption value at maturity and the purchase price;
the search for capital gains deriving from the sale of the security, before its maturity, at a price higher than the purchase price – a typically speculative investment activity.
So let's proceed like this: let's analyze the two reasons for investing separately and then draw conclusions.
Life as a cashier
Let's assume we are a "drawer" investor with well-functioning neurons: in this case, the goal is to obtain a real positive return.
The real yield comes from a daring calculation, a subtraction, which I venture to write:
real yield = nominal yield to maturity – inflation
The first term, the nominal yield to maturity (or yield to maturity) is known, because it derives from the quotation: you can read it in newspapers or on specialized sites, such as Bloomberg.
The second term, being an argument about the future, is expected inflation. Slightly more difficult to estimate. But in hindsight not so much: the European Central Bank has an annual inflation target of 2%. And since square people work at the BCE, in the medium to long term you can count on them not straying far from that number.
In fact, consider that, from the birth of the Euro up to the Lehman Brothers crisis, annual inflation averaged 1,9%. Including the crises, with a side note of recession and various problems in the Eurozone, the figure goes to 1,6%, not far from the target of 2%.
Moral: one can have decent estimates of the yield to maturity of Italian government bonds; you can find them in the following graph.
In short, to find a marginally positive real return you need to invest in BTPs for over 10 years, in the hope that in the end the current government will return your money. Already. It might not even happen... In fact, consider that the real component of the return is in turn broken down into two terms:
- the remuneration offered to you by the market for depriving you of money for a while – the so-called term premium;
- the remuneration of the risk that the creditor (in this case the State) does not pay, i.e. the risk of default.
Now, "extracting" from the market data the probability of Italy's default, it emerges that it is approximately 12,5% over a period of 5 years, and approximately 23% over 10 years. The longer the deadline, the more the probability of default rises. They are not the most reliable numbers in this world, OK, but one thing is certain: the probability of Italy's default is not zero.
Do you understand the mystery? So, in summary, if you intend to pursue a career as a drawer:
- on short and medium maturities you lend money obtaining in exchange a real negative gain – which means that you do not want to be remunerated for the deprivation of money, on the contrary, you are willing to pay for it (a real cool thing);
- on long maturities, in real terms you earn something, but little (1,1% at 50 years), and you are at risk of default - I don't know how you see it, but based on the bizarre speeches made around by certain characters in the team dominant policy I believe that default is not an eventuality that should be excluded a priori.
Looking for capital gain
If you've seen the movie Wall Street many times and feel a bit like Gordon Gekko, you might be the capital gains-seeking type. This means only one thing: that you aim to see interest rates fall. However, if interest rates were to rise, you would lose. Simple.
So, let's see if it is plausible that interest rates will fall and that you will get the coveted capital gains by buying the BTPs today. Consider the following:
- the phase of global expansive monetary policy, the one that keeps interest rates low, is also fading in the Eurozone, due to the general improvement in economic conditions;
- real interest rates are negative on many maturities, and this – as we have seen – is against nature, it is an economic abomination that cannot continue forever; this implies that nominal yields will tend to rise (perhaps slowly, if there are no financial or economic shocks);
- if, as it seems, cheerful initiatives such as the basic income, the abolition of the Fornero reform and the flat tax are carried out, barring miracles (in which I personally don't believe much) the Italian public debt will swell and the yields of the BTPs will rise to reflect the greater probability of Italy's default;
- finally, just look at the historical distribution of returns on BTPs (see chart below) to understand the anomaly of recent years - bear in mind that the further away the returns are from the average, the more likely it is that they will return towards it, going up (it is the mean reversion).
Don't panic
The fact that BTPs have unattractive yields and that the probability of a fall in yields (and therefore an increase in BTP prices) is low does not mean that Italian bonds are on the verge of an imminent catastrophe. They could just float around the current levels, swinging randomly. As indeed they have already been doing for a few months. Waiting for something.
However, I leave it to each of you to conclude the reasoning and answer the question: does it make sense to invest in BTPs today? You should have all the elements to be able to process it correctly. After that there's not much more to say: time will give us the opportunity to look the merciless truth in the eye.
