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By Natsuko Waki
February 2, 2012 3:21 AM EST
Italy's bonds have made sizzling returns this year but fears the country will lose its investment-grade status are putting off long-term investors whose support Rome needs to tackle a mountain of refinancing and ease worries about its debt.
Potential buyers worry that further downgrades would prompt Italy's removal from benchmark indices tracked by "passive" bond funds and exchange-traded funds, which would then be forced to dump their holdings. To make matters worse, credit worries are also distorting the market for Italy's inflation-linked debt.
With a combined 93 billion euros (77.4 billion pounds) held in Europe, the behaviour of such funds is critical to the performance of Italy's government bond market, the world's third largest.
JP Morgan estimates approximately 140 billion euros of Italian debt is still held worldwide by managers who track global or euro government bond benchmarks, of which Italy's debt takes about a 20 percent share.
Italy is currently rated a mid- or low-investment grade by the three major ratings agencies, but is seen as vulnerable to further downgrades. An across-the-board cut to "junk" would trigger its exclusion from top-rated government bond benchmarks and force passive index trackers to automatically sell the debt.
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"They are on the cusp of exiting some of the indices. Ratings drive benchmarks and it's legally binding. It's absolutely critical for market action," said Richard Batty, investment strategist at Standard Life Investments, which has $233 billion (147 billion pounds) under management.
Citing Greece's 2010 downgrade to junk as a precedent, JP Morgan warns central bank reserve managers might also be forced to offload their 65 billion euros of Italian government debt if the sovereign were to lose its investment-grade status.
Central banks often hold their euro currency reserves in the form of government bonds.
Despite these worries, and concerns about the stability of the wider euro zone, Italy's are among the best-performing government bonds this year, with total returns of more than 8 percent on its benchmark 10-year debt.
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Global government bond returns 2012 http://bit.ly/wy87m7
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Demand for its paper has largely been driven by domestic banks, which have used some of last month's cheap loans from the European Central Bank to lock in higher yields on euro sovereign bonds, and those of Italy in particular.
The ECB lent almost half a trillion euros at December's unprecedented three-year operation, kick-starting a recovery in global markets, and is expected to inject another 325 billion euros at a second such tender this month.
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