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This article was originally published on ETFTrends.com.
The iShares MSCI Italy Capped ETF (EWI) , the largest US-listed exchange traded fund dedicated to Italian equities, is lower by more than 16% year-to-date. That is enough to make EWI one of the worst-performing ETFs tracking a developed economy.
EWI is not the only ETF being pinched by problems in the Eurozone's third-largest economy. Some fixed income ETFs with exposure to Italian bonds are being pinched as well. That includes the Vanguard Total International Bond ETF (NasdaqGM: BNDX) and the iShares International High Yield Bond ETF (CBOE:HYXU) .
Last week, the European Commission formally notified Italy that its 2019 budget plans were a serious problem and required “clarification” over the “unprecedented” deviation from E.U. rules, AFP News reported.
“The lack of contagion to other peripheral eurozone issuers, while welcome, should not lull investors into a false sense of security,” said Morningstar in a recent note. “Italy’s problems on their own do matter--a lot, in fact. Italy has the largest government bond market in the eurozone and the third largest in the world after the United States and Japan. This means that passive funds providing exposure to international sovereign bond markets, which for most U.S.-based investors are a tactical investment, can have a large weighting in Italian bonds.”
Meanwhile, bond investors have also been selling off Italian debt in response to the concerns, with yields on 10-year government debt hitting their highest since 2014.
HYXU, which tracks the Markit iBoxx Global Developed Markets ex-US High Yield Index, allocates nearly 20% of its weight to Italian bonds, its largest country weight by almost 330 basis points.
“Typically, developed sovereign bond market passive funds track benchmarks that require issuing governments to be rated investment-grade,” said Morningstar. “his means that a downgrade of Italy to junk would turn the funds into forced sellers at the worst possible time. Given the large weight of Italy in these indexes, it is easy to imagine a situation where downside pressure to prices is magnified by the sheer volume of bonds that these passive funds--and active funds unable to invest in non-investment-grade debt--would have to shed and, thus, the cost that investors would have to bear.”
Italy argued that the increased spending plan was necessary to bolster growth, which will eventually push down debt, and the higher deficit will subsequently fall as a result, according to the Associated Press.
“Besides, a downgrade to junk would also mean that the European Central Bank may be technically barred from coming to the rescue, which would add fuel to the anti-euro rhetoric of this Italian government,” according to Morningstar.
For more information on the bond market, please visit our Fixed Income Channel.