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Italy once again took the spotlight in the markets yesterday, but this time it wasn’t about Berlusconi’s resignation. As it turned out, Italy’s bond yield levels also warrant close attention.

Remember that bond yields are very similar to how your local bank charges interest on its loans.

When banks loan out money, they try to match the interest they charge to the risk they take. If the risk is high, then they must be compensated with higher interest payments. In this case, the investors are the “banks” and Italy is the “borrower.”

Italy’s 10-year bond yields rose to as high as 7.45% before settling at 7.05% yesterday, the highest level since the euro was created. The problem with this figure is that it’s above the psychological 7% level where countries like Greece, Ireland, and Portugal began asking for bailout packages.

Euro Zone bond yields and bailouts

What exactly boosted Italy’s bond yields yesterday?

A lot of factors came into play, but one of the major issues is the lack of details on Berlusconi’s resignation. After the news boosted risk appetite last Tuesday, his critics are now calling for more details on how to give him the sack as soon as possible.

It also didn’t help that LCH Clearnet SA, a firm that guarantees the completion of investors’ trades, fueled the bailout déjà vu by increasing its margins on Italian bond trading.

The firm hiked its initial margin by a range of 3.5%-5.0% across all maturities of Italian treasury and government-related bonds. If you remember, this is exactly what the firm did for Portuguese and Irish bonds just before they asked for a bailout. Yikes!

The last and probably the biggest contributor to yesterday’s risk aversion is the increasing concern on Italy’s ability to pay its debts. Lemme give you a brief background of Italy’s debt scenario.

Italy currently has the third largest bond market in the world and also has a high debt-to-GDP ratio of 120%. What separates it from the rest of the PIIGS though, is that it doesn’t need to borrow money to keep the country from rolling.

It merely needs to borrow in order to pay off interest and principal payments of its existing debt. Basically, Italy is just refinancing its debt.

The problem though, is that the continuous rise of Italian debt could prove troublesome for Italy.

Concerns on whether Italy can repay all its debt may continue to scare investors away and the country would be left in a situation where there wouldn’t be any buyers left, no matter how high yields become in order to entice investors.

So, should we start anticipating an Italian bailout?

Not necessarily. Because Italy only has to borrow debt to cover maturing bonds, it can still get by as long as the timing is right.

The Italian government only needs to cover parts of its overall debt at any given moment, so as long as yields aren’t too high, it can continue to sell bonds, even at steep discounts.

Furthermore, if and when Berlusconi finally steps down as Prime Minister, this should help stabilize the political scene. Berlusconi has long been one of the party poopers in the Italian government and his farewell might convince investors to buy back Italian bonds.

For now, it appears that the current issues are a question of confidence and not liquidity. The key will be managing the problem so that it does not escalate to that latter stage.