Trading and Capital-Markets Activities Manual
Profiles: Italian Government Bonds and Notes
The Italian Treasury issues bonds, notes, and bills, which are guaranteed by the Italian government. These securities are issued with maturities ranging from three months to 30 years in a wide variety of structures. These structures include Treasury bonds, Treasury floating-rate notes, Treasury notes with a put option, and short-term Treasury bills. The Treasury also issues notes and bills denominated in European Currency Units (ECUs). Government securities are issued in book-entry form but may be converted to bearer form following issuance.
CHARACTERISTICS AND FEATURES
Treasury bonds, or Buoni del Tesero Poliennali (BTPs), are fixed-coupon medium- to long-term government bonds with semi-annual dividend payments. These bonds have played an important role in financing the Treasury, especially after the establishment of the Telematic Market for government bonds, which provides the liquidity necessary for these instruments. These bonds are issued with 5-, 10-, and 30-year maturities in denominations of lire 5, 10, 50, 100, 500, and 1,000 million. Interest on these bonds is paid through deferred semi-annual coupons.
Treasury floating-rate notes, or Certificati di Credito del Tesoro (CCTs), are floating-rate notes indexed to T-bill rates. CCTs are generally issued in denominations of lire 5, 10, 50, 100, 500, and 1,000 million, with 7-year maturities, although 5- and 10-year notes have also become popular. Interest on these bonds is paid through deferred semi-annual or annual dividend coupons, with rates indexed to Italian Treasury Bill (BOT) yields. For BOTs issued after December 1994, the coupon is calculated by adding a spread of 30 basis points to the six-month T-bill recorded in the last auction. For issues before December 1994, the coupon is calculated by adding a spread of 30 basis points to the average gross semi-annual yields of one-year BOTs auctioned in the second and third months preceding the coupon period.
Treasury notes with options, or Certificati del Tesoro con Opzione (CTOs), are fixed-coupon securities with an embedded put. The embedded option in the CTO permits investors to redeem the bond halfway through nominal maturity, and it is designed to encourage investors to extend their investment horizons. Any request for refunding must be forwarded within an 11-day period beginning precisely one month before the scheduled date for anticipated redemption. The bonds are issued in maturities similar to BTPs. The Treasury has not issued any CTOs since May 1992.
Treasury notes denominated in ECUs, or Certificati del Tesoro in ECU (CTEs), were introduced by the Italian government in 1982 as part of an effort to diversify the instruments issued for financing public deficits. They are fixed-coupon ECU-denominated bonds issued in denominations of ECU 5,000, 10,000, 100,000, 500,000, and 1 million, generally with a five-year maturity. The foreign-currency weighting of the CTEs is attractive to investors who fear devaluation of Italian exchange rates. Interest on these bonds is paid in the form of deferred annual coupons in ECUs or, at the holder's request, in an ECU-equivalent lira amount.
Domestic and international settlement of Italian government bonds takes place three business dates after the trade date (T+3). The only exception is BOTs, which settle two business dates after the trade date (T+2). Italian government bonds with a coupon can be settled via Euroclear or Cedel. Settlement through Euroclear and Cedel takes five days. Interest is calculated using a 30/360-day count in which each month is assumed to have 30 days.
Italian government securities are used for investment, hedging, and speculative purposes. While investors may buy Italian bonds as part of diversifying their investment portfolios, the bonds may also be used to hedge positions that are sensitive to movements in interest rates. Speculators, on the other hand, may use long-term bonds to take positions on changes in the level and term structure of interest rates.
DESCRIPTION OF MARKETPLACE
Italian government bonds are issued via a marginal auction, in which there is no base price. Each allotment is made at the marginal accepted bid which represents the stop-out price, below which no bids are considered. Partial allotments may be given at the stop-out price if the amount bid at that price exceeds the amount not covered by the higher-priced bids. Each participant is limited to three bids. The exclusion price, or the price below which no bids will be accepted, is calculated by listing the bids in decreasing order and proceeding as follows:
If the amount of competitive bids is greater than or equal to the amount offered-
- take the amount of bids (in a decreasing
price order) needed to cover half the offered amount,
If the amount of competitive bids is less than the amount offered-
- take half of the bids in a decreasing
Once the exclusion yield is calculated, bids are accepted in decreasing order of price. Bids are accepted to the point that covers the amount to be offered up to the stop-out price. Partial allotments may be given at the stop-out price if the amount bid at that price exceeds the amount not covered by the higher-priced bids. Non-competitive bids may also be accepted and awarded at the average of accepted competitive bids plus a Treasury spread.
The Treasury makes an announcement of auction dates annually and also makes a quarterly announcement of the types of bonds and minimum issue sizes to be offered in the following three months. The auctions are held at the beginning and middle of the month. Generally, 3- and 5-year bills are sold on the same day, 10- and 30-year bonds are sold together, and CCTs are sold on the third day of the auctions.
The Bank of Italy may reopen issues, that is, sell new tranches of existing bonds, until the level outstanding reaches a certain volume, generally over lire 10 trillion. After that threshold volume is reached, a new bond must be issued. If an issue is reopened, the Bank of Italy issues new tranches of securities with the same maturities, coupons, and repayment characteristics as existing debt. The ability to reopen issues improves liquidity and avoids the potential poor pricing of securities that often occurs when a market is flooded with one very large issue.
Italian government bonds can be traded on any of the following: the Milan Stock Exchange, the telematic government bond spot market (Mercato Telematico dei Titoli di Stato or MTS), and the over-the-counter (OTC) market. Bonds may be traded on the Milan Stock Exchange if they are transformed into bearer bonds (at least six months after being issued). The stock exchange is the reference market for the small saver as only small dealings are transacted there. At the end of the day, the exchange publishes an official list of the prices and volumes of trading. The MTS is the reference market for professional dealers.
Only banks authorized by the government of Italy may act as primary dealers of Italian government bonds. Branches of foreign banks and non-financial institutions can also act as dealers, provided they are residents in the European Union and subject to comparable financial regulations.
A wide range of investors use Italian government bonds for investing, hedging, and speculation. This includes domestic banks, non-financial corporate and quasi-corporate public and private enterprises, insurance companies, and private investors. Foreign investors, including U.S. commercial banks, securities firms, insurance companies, and money managers, are also active in the Italian government bond market.
The Italian government bond market is an active one. Price transparency is relatively high for Italian government securities as several information vendors, including Reuters, disseminate prices to the investing public.
Prices and yields of Italian government securities are stated as a percentage of par to two decimal places. For instance, a price of 97.50 means that the price of the bond is 97.50 percent of par. The price spread is generally narrow due to the efficiency of the market.
Bonds trade on a clean-price basis, quoted net of accrued interest. Italian government bonds do not trade ex-dividend. Interest on Italian bonds is accrued from the previous coupon date to the settlement date (inclusive). In this regard, Italian bonds pay an extra day of interest compared with other bond markets.
Italian government bonds can be hedged for interest-rate risk in the Italian futures market (Mercato Italiano Futures or MIF) as well as the London International Financial Futures Exchange (LIFFE). The MIF and LIFFE offer futures on 10-year Italian government securities, and the MIF offers futures on five-year Italian government securities. The LIFFE also offers OTC options on individual bonds as well as options on futures contracts. OTC forwards and swaps can also be used to hedge interest-rate risk.
The effectiveness of a hedge depends on the yield-curve and basis risk. For example, hedging a position in a five-year note with an over-hedged position in a two-year note may expose the dealer to yield-curve risk. Hedging a 30-year bond with an Italian bond future exposes the dealer to basis risk if the historical price relationships between futures and cash markets are not stable. Additionally, if a position in notes or bonds is hedged using an OTC option, the relative illiquidity of the option may diminish the effectiveness of the hedge.
The Italian bond market is one of the most liquid markets in the world. Liquidity is maintained by 40 market makers, which include 16 specialists, top-tier market makers (Morgan Guaranty, Milan), and 24 other market makers who are obligated to quote two-way prices. Ten market makers have privileged access to the Bank of Italy on the afternoon of an auction to buy extra bonds at the auction price. The purchases are subject to a limit set by the Bank. For instance, if a particular issue were oversubscribed and prices were likely to shoot up, the selected market makers would be able to buy more of the same bond and maintain or increase market liquidity.
As discussed above, the Bank of Italy may reopen issues until they reach a certain volume before selling a new bond. The ability to reopen issues improves liquidity and avoids the unfavorable pricing which may occur if the market is flooded with one very large issue. Liquidity is also maintained by limiting the number of government entities that issue debt. In the case of Italy, only the central government may issue debt securities.
Italian government bonds are subject to price fluctuations due to changes in interest rates. Longer-term issues have more price volatility than shorter-term instruments. Therefore, a large concentration of longer-term maturities in an investment portfolio may increase interest-rate risk.
From a U.S. investor's perspective, there are two types of risk related to foreign bonds: (1) the coupons and face value are paid in the foreign currency, which means that any change in the exchange rate affects the bond's value to the U.S. investor, and (2) the bond's yield may be affected by currency movements. A number of factors exert a direct influence on foreign exchange rates, including the balance of payments and prospective changes in that balance; inflation and interest-rate differentials between Italy and the United States; the social and political environment in Italy, particularly with regard to the impact on foreign investment; and central bank intervention in the currency markets.
A change in the political environment, withholding tax laws, or market regulation can have an adverse impact on the value and liquidity of an investment in foreign bonds. Investors should be familiar with the local laws and regulations governing foreign bond issuance, trading, transactions, and authorized counterparties.
The accounting treatment for investments in foreign debt is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.)
RISK-BASED CAPITAL WEIGHTING
Italian government bonds and notes are assigned to the 0 percent risk-weight category.
LEGAL LIMITATIONS FOR BANK INVESTMENT
Italian government notes and bonds are type III securities. As such, a bank's investment in them is limited to 10 percent of its equity capital and reserves.
Banca d'Italia. Economic Bulletin.
Number 23, October 1996.
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