By Avantika Chilkoti and Paul J. Davies
Investors are shunning Italian government bonds after the country became Europe's epicenter for the coronavirus outbreak this week, leading to renewed worries about one of the region's most indebted economies.
Yields on the country's 10-year bonds rose, while those on German and French debt slid, signaling that fixed-income investors in Europe are pulling out of Italian sovereign debt and heading instead for the safety offered by less indebted economies. The week has also seen a sharp selloff in equities and other risky assets globally because of fears about how growth might suffer during a prolonged outbreak.
Investors tend to rush to the safety of government bonds when the world looks riskier. But in southern European countries such as Italy, Spain, Greece and Portugal, investor skittishness has tended to infect sovereign-debt markets, too, in recent years. Since the 2008 financial crisis and the subsequent eurozone crisis of 2011 and 2012, these countries' high debt levels and worse economic problems have made them more susceptible to selloffs.
Investors' move from riskier to safer government bonds has sharply increased the extra yield on Italian debt over German debt. On Thursday, that extra yield -- or spread -- on Italian 10-year bonds rose to 1.617 percentage points, which is up from the recent low of 1.287 percentage points two weeks ago, according to FactSet.
Part of this is German yields falling as investors rushed for safety as well as Italian yields rising: German 10-year yields slipped to minus 0.542% on Thursday from minus 0.445% at the end of last week. Italian yields jumped to 1.075% from 0.896% in the same period.
However, that is still far below the spread of more than 3 percentage points reached in late 2018, when Italy's government was building up to a showdown with the European Union's leadership over its generous spending and borrowing plans and fears rose that it could ultimately leave the eurozone.
Since then, the U.S. and European central banks have been forced back into interest-rate cuts and government-bond buying to support the economy and relive financial strains.
Some analysts think the selloff in Italian bonds could be a lot worse. The reason: Italian yields have been contained by investors' expectations that any serious economic disruption would lead to an increase in the European Central Bank's bond-buying program, which was restarted late last year in an effort to boost inflation. Yields on Spanish and Portuguese bonds have also risen, though much less than Italy's, while Greek bond yields have jumped the most.
"If they think if the eurozone is very weak -- and Italy is a big part of that -- the ECB is going to have to act, and one of the things they're going to do is buy the bonds," said Tom Kinmonth, senior fixed-income strategist at ABN Amro Bank NV.
Even though Italian bonds are being sold down, in general the market is still favoring central-bank assets as the fast-spreading epidemic leads to anxiety about economic growth, said Alberto Gallo, head of macro strategies at fund manager Algebris.
"We know that this is going to end up in fiscal and monetary stimulus, so we are not likely to bet against government debt from here," Mr. Gallo said.
Italian government debt could be among the biggest beneficiaries of ECB efforts to support the economy because it owns a smaller share of the country's bonds than most, which means it has room to buy more Italian debt before hitting limits.
Investors have grown jittery as the coronavirus outbreak has spread across Italy. By Thursday, 528 people in the country had contracted the virus, of whom 14 had died, making Italy the biggest epicenter outside Asia.
The virus has particularly hit the regions of Lombardy, which generates 22% of Italy's economic output, and Veneto, which contributes a further 9%, according to estimates from Commerzbank. Some companies in the affected regions have reported a halving in production because of canceled orders, analysts at the bank said.
Equities in Italy have suffered alongside bonds. The benchmark FTSE MIB index dropped more than 9% over the past week, roughly in line with the broader European market.
For the bond market, however, the pickup in yields may become hard to resist for investors starved for income. The rise in yields is likely to be short-lived, according to Didier Saint Georges, managing director at Carmignac, a European asset manager.
"There is a scarcity effect," Mr. Saint Georges said. "We don't have that many [countries] where you can still get positive yields on short-term maturities in Europe."
Write to Avantika Chilkoti at Avantika.Chilkoti@wsj.com and Paul J. Davies at email@example.com