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 that further downgrades for Italy would see its linkers excluded from a key Barclays Capital index – prompting mass sales by fund managers. Italian debt currently makes up more than a quarter of the index, but Barclays Capital confirms that no exception would be made for the country.

The rules of the Barclays Capital euro government inflation-linked bond index state that linkers are excluded when the issuer is rated lower than A3 or A- by two of the three big rating agencies. Italy is currently rated one notch above that threshold by Moody’s Investors Service and Standard & Poor’s (S&P), and two 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 the head of inflation at one European asset manager.

“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.

The asset manager’s funds track the Barclays Capital index, and the inflation head 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.

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