Dealers call for ECB to buy inflation bonds as Italy faces exit from key index

Further downgrades for Italy would cause its inflation-linked bonds to drop out of a Barclays Capital index, prompting mass selling by fund managers, dealers fear

Dealers are lobbying the European Central Bank (ECB) to expand its bond-buying remit to include inflation-linked debt, amid fears further downgrades for Italy would see its linkers excluded from a key Barclays Capital index – prompting mass sales by fund managers. Italian debt makes up more than a quarter of the index, but Barclays Capital confirms no exception would be made for the country.

The rules of the Barclays Capital euro government inflation-linked bond index state linkers are excluded when the issuer is rated lower than A3 or A– by two of the three big rating agencies. Italy is rated two notches above that threshold by Moody's Investors Service and Standard & Poor's (S&P), and three notches higher by Fitch Ratings.

Further downgrades would force funds tracking the index to sell Italian linkers, dealers warn. "There is a large swath of index-tracking funds and, if you take Greece as a case study, there's forced selling from people who use that as a benchmark if there are downgrades. The consequence of that, all else being equal, is an increase in real yields and a reduction in breakevens for Italy," says the head of inflation structuring at one large European bank.

Some funds are already acting on these fears, according to one US bank's head of inflation trading. "There were some quite big flows out of a European linker fund into a global fund at the end of last year – that was one of the reasons the UK's 2029 linker syndication at the end of November went very well," he says.

Not all funds are compelled to mirror the index, but many could sell anyway, says Laurent Gonon, fixed-income portfolio manager and head of inflation at Amundi, the asset management business established by Crédit Agricole and Société Générale.

There is a probability that the downgrades happen, and we have to consider what we would do in that environment

"For most funds, the minimum rating is BBB– or investment grade, so not all fund managers will be forced to sell Italian linkers in a hurry just because they drop out of the index. But they will usually sell, because it means liquidity is reduced and there is a higher risk of tracking error versus the benchmark," he says.

Amundi's funds track the Barclays Capital index, and Gonon says it is taking a cautious attitude to Italian linkers, although it would not necessarily abandon them if they fall out of the index. "There is a probability that the downgrades happen, and we have to consider what we would do in that environment. We take a cautious approach to Italian linkers today, probably like most other fund managers. I would expect many would already be underweight on Italy due to this specific issue," he says.

The US bank's inflation trading head does not agree. "I know of quite a few pension funds that have put money into Italian linkers in the second half of this year – they want to get inflation protection, they felt Italy was unlikely to default, and they're getting pretty good value as Italy has outperformed since the summer," he says.

Barclays Capital says Italy, which accounted for 28.4% of the euro government linker index as of December 31, would not be treated as a special case. "If a particular bond no longer meets the eligibility criteria, it would exit the index at the next monthly rebalancing date," says Brian Upbin, New York-based head of benchmark index research at the bank. "This transparency on objectivity in index construction is an important characteristic that the market relies on for clarity around index eligibility."

As such, dealers say intervention is needed – and a number have had discussions with the ECB, arguing it ought to include linkers in its securities markets programme (SMP) to stop breakevens falling. "By buying conventional bonds but not linkers, you are by definition altering inflation expectations, and at a time of economic uncertainty and lack of confidence, you don't want to be lowering inflation breakevens – you probably want to be raising them," says the US bank's head of inflation trading.

Continuing to exclude linkers from the SMP could have even broader ramifications, the European bank's head of inflation structuring says. "It causes significant damage to the inflation market globally, because you've effectively created a precedent where the two types of bond are not treated equally and fairly by the authorities," he says. But the ECB – understandably, dealers admit – has bigger problems to address first.

Italy's treasury, the Dipartimento del Tesoro, tackled the problem with switch auctions, buying linkers in exchange for nominal bonds, in December. But dealers are unsatisfied with its efforts, and the Tesoro could not be reached for comment for this article. "It was miles off the market price, exactly the opposite of what you'd want. It offered some of the switches at punitive terms – up to a point away from market prices, which is even worse than not offering a switch at all," says the European bank's head of inflation structuring.

Another senior London-based inflation trader concurs. "The 2023 buy-back went really well – people were able to sell at decent levels, but the 2017 one was very cheap. This is why dealers don't consider this to be good enough support for the market – there is no consistency to it. These buy-backs got concentrated in a few issuances, and there hasn't been a clear statement from the ECB, the treasury or the Bank of Italy, saying they will support the linker market," she says.