Contagion creeps back into Europe’s bond markets

Italian credit downgrade by Moody’s is likely to add to pressure

Concerns over Italy’s finances spread to other European bond markets this week, in a worrying sign for investors who until recently hoped that market jitters would be contained.

The gap in yield between 10year Spanish bonds and haven German debt hit its widest level since April 2017 during Friday’s session before narrowing later in the day, according to Refinitv, while Portuguese debt also came under pressure.

The selloff eased in European afternoon trading Friday—with Italian and other bonds rallying after 10-year Italian yields hit their highest level since early 2014 earlier in the day. That turnaround came after a senior EU official played down tensions with Italy’s antiestablishment government.

But investors predicted the standoff between Brussels and Rome will continue, likely keeping markets volatile.

Italian bond yields have risen sharply since late September when the country’s government set a 2.4% budget deficit target that put it at odds with the European Commission. But investors hadn’t sold the debt of other weaker Southern European economies. That kind of market contagion has rarely been seen since the depths of the eurozone sovereign-debt crisis over six years ago. That changed this week, as the extra yield premium investors demand to hold Spanish debt over similar German bonds climbed to 1.33 percentage point, according to Refinitiv, compared with around 1 percentage point in late September.

“People are very focused on

[the] downside risk to Italy and it has spilled over more in the last couple of sessions,” said Ryan Myerberg, a portfolio manager at Janus Henderson Investors.

Mr. Myerberg said Spain and Portugal’s finances look solid. But in the short-term, something of a “perfect storm” could cause their bonds to slide, including concerns over creditrating firms downgrading Italy and crowded positioning in Spanish debt.

“They won’t be immune if Italy continues to move higher in yields,” he said.

Italy is the eurozone’s third largest economy and has a public debt load that equates to around 130% of gross domestic product. Analysts fear that if Italy crashed out of the common currency, other weaker economies would be dragged to the exit with it.

The EU’s executive arm warned Italy’s government in a letter on Thursday that its budget plans appear to violate commitments to reduce its debt and deficit. The fact that Rome has opted to expand its deficit instead of cutting it, and the scale of the deviation from previous promises, “are unprecedented in the history of the Stability and Growth Pact,” the Brusselsbased European Commission wrote, referring to the EU’s fiscal rules.

The government has said it won’t change its plans to boost welfare and pension spending and cut taxes, even if the commission launches disciplinary proceedings, which could potentially lead to financial penalties for Italy.

The continuing selloff in Italian bonds challenges government officials’ claim that financial markets are more relaxed

about their economic policies than Brussels. The bond selloff is also hurting Italy’s banking sector, which is heavily exposed to the government’s debt.

But despite bouts of anti-euro rhetoric from Rome’s antiestablishment government, most analysts still see a eurozone breakup as very unlikely.

“The recent [bond market] move is not a European break up driven move,” said Mr. Myerberg.

Many investors still expect Rome and Italy to reach an agreement on the Italian budget. That may take some time, though, meaning bond markets are likely to stay volatile.

“We’re looking for a resolution,” though it may not come until December, said Adrian Helfert, senior portfolio manager at Amundi.

“There’ll be an entry point” to buy Italian debt, he said.