Photo: AFP/Paco Serinelli
Photo: AFP/Paco Serinelli

The difference between the 5-Year credit default swap spreads for the Republic of Italy and Unicredito, respectively, is now at its lowest level on record.

The difference gauges the risk that the Italian sovereign might choose to repay its bonds in a devalued new Italian lira rather than with the euros in which they were issued. Corporates like Unicredito have no such option (all of its bonds have covenants requiring repayment in the currency in which they were issued).

There may be some idiosyncratic market technicals at work, but the credit default swap market still registers a far more dire level of risk than the Italian government bond market. There is considerable speculation that the Italian Treasury intervened heavily in the bond market to ensure the success of last week’s government bond auction after panic selling of Italian debt at the beginning of the week.

Over time the Italy CDS spread tracks the Bund-BTPS spread closely. During the past week the relationship broke down and CDS spreads remain much wider than the German-Italy spread would indicate.

Why should this be the case? The Italian Treasury (and other official institutions) can intervene in the Italian bond market via cash or futures, but they cannot easily influence the CDS market. The private sector is effectively shut off from credit.