Political risk is back with a vengeance in Italy. As the third largest global issuer of government bonds after the US and Japan, the country is too big to be allowed to fail without severe contagion to the global financial system. However, it is also too big to bail out comfortably using tried and tested mechanisms.
With the country saddled with high debt and unstable politics, Italian debt markets have persistently underperformed European averages for the last couple of years. This pessimistic narrative is definitely seductive but we believe it is dangerous to get sucked into an excessively negative outlook. The debt problems are chronic rather than acute, the politics are not obviously more unstable than usual, the ECB is being flexible with asset purchases, and the return potential could be greater than it first appears.