Analysis: The rating game - 'Junk' Italy still hard to imagine, funds say

By Abhinav Ramnarayan and Virginia Furness

LONDON (Reuters) - For Italy's sovereign debt the timing could hardly be worse: A budget standoff with Brussels is driving the country's bond yields to new peaks, just as two credit agencies are weighing whether to cut their ratings to within one notch of 'junk'.

But as markets move to price in chances of the euro zone's biggest sovereign bond market losing its investment grade rating, major bond investors reckon political factors and significant contagion risk make that almost inconceivable.

Moody's and S&P Global, both rating Italy two rungs above 'junk', are widely expected to downgrade in late October as the new government's outsize spending plans put it on a collision course with EU authorities.

One rung lower and Italy would fall below investment grade for the first time, a move that would potentially cost it hundreds of billions of euros in lost bond investments.

The conundrum for financial investors is how to accurately price the risk of a euro zone sovereign in junk territory - given that particular sovereign's market footprint, the complication of still-active European Central Bank bond buying, eligibility rules for that ECB support and an outside risk to Italy's euro membership.

HOW WIDE IS TOO WIDE?

Some think current Italian government benchmark bond spreads - which hit a five-year high of 312 basis points over German Bunds on Tuesday - and credit default swaps pricing already show the country trading as a junk-rated borrower.

Kaspar Hense, portfolio manager at BlueBay Asset Management, said an Italy/Germany 10-year spread of 300 basis points was more compatible with a junk-rated issuer, based on a model comparing Italy with other developed and emerging market sovereigns.

The main credit agencies say their rating decisions are guided solely by credit analysis and not any wider political backdrop.

But investors are wary that current debt pricing comparisons may be misleading as they don't account for political sensitivities, given the sheer scale of Italy's bond market and its systemic importance to the euro zone project.

"A downgrade to junk could trigger a full-blown (euro zone) crisis," said Nicola Mai, a portfolio manager at PIMCO, the world's largest bond investor. "...Which is why I don't the agencies will do it, I don't think they will want to be the ones causing a crisis in Europe."

Iain Stealey, a fixed income portfolio manager at JP Morgan Asset Management - another bulge bracket bond investor - also said a junk-rated Italy was highly unlikely.

"It would be a very, very big decision, just given the size of the Italian bond market, it makes up something like a fifth of government bonds in the euro zone," he said.

That backdrop suggests the bar is higher for Rome than other borrowers, and the possibility of a junk rating is therefore only partially factored in.

Goldman Sachs and Bank of America Merrill Lynch said last month in separate notes they reckoned full pricing in would equate to an Italy/Germany yield spread of 400 bps.

At the height of the euro zone debt crisis the spread went even higher, to over 550 basis points, and the country still kept its investment grade ratings - though that was without the effect of the ECB's bond-buying scheme.

However the numbers are parsed, anxiety over the ratings risk is likely to persist.

"The threat of a junk rating won't go away while the current coalition is in partnership," said John Taylor, fixed income portfolio manager at AllianceBernstein, a fund with $546 billion of assets under management.

WHAT'S AT STAKE

Italy comprises about 22 percent of the 1.346 trillion euro iBoxx EUR Eurozone index, 5.7 percent of $1.35 trillion ICE BofAML Global Government Index and 7.53 percent FTSE Russell World Government Bond Index, which is tracked by $800 billion of assets.

Most major indexes, such as iBoxx and the Bloomberg/Barclays euro aggregate index, which has a market value of over 10 trillion euros ($11.8 trillion), use the average ratings of Moody's, S&P and Fitch.

So downgrades to junk from two of these agencies would be enough to take Italy out of these indexes.

The ECB, on the other hand, would require all three major agencies plus DBRS to cut to junk to take Italy out of its bond-buying programme.

This issue becomes sharper as the ECB unwinds the programme this year. When Portugal was merely faced with the threat of that fourth downgrade from DBRS in August 2016 -- it never actually came to pass -- its 10-year bond yield spread over Germany widened 80 basis points in just under two months.

Given the complexities and sensitivities, some feel they may just kick any decision far down the road.

"The ratings agencies will give an issuer as influential as Italy a lot of time," said Stealey of JP Morgan AM.

(Reporting by Abhinav Ramnarayan and Virginia Furness; Editing by Mike Dolan and John Stonestreet)