By Mike Bird 

The prospective antiestablishment government of Italy has shocked markets, with bond yields jumping higher on the potential for anti-euro policy positions and a burst of new government spending.

That puts investors who have funneled gobs of money betting on Italy's economic recovery in a difficult position: stick around for a volatile ride or turn tail.

"There's a wall of money that's likely to step back from Italy," said Chris Iggo, chief investment officer of fixed income at AXA Investment Managers. "A lot of investors have been overweight Italy, they've been higher yielding, it's not surprising to see people closing those long positions."

In the past week investors have driven Italy's 10-year government bond yields up by around half a percentage point compared with their German peers to 1.75 percentage points, the fastest increase in around five years, leaving them wondering how far conditions can deteriorate.

Until recently Italy was regarded as a market darling. Investors have been particularly enamored with Italy's banks, which are seen as having turned the corner on resolving a monumental pile of bad loans. Italy's broader stock market had beat both the rest of Europe and the U.S., and government bond yields were falling against those of other countries.

Then an election in March left Italian political mainstream parties lagging, and gave two antiestablishment political parties -- Lega and the 5 Star Movement -- with a narrow parliamentary majority. A leaked draft agreement between the two parties included proposed debt write-offs and huge spending commitments that would risk the country's membership of the euro.

That helped spark the bond sell off in recent days. Despite that, Italian bond yields remain low compared with their historic highs. As recently as the tumult leading up to the French presidential election in March 2017, spreads between German and Italian 10-year yields passed 2 percentage points. In the midst of Europe's sovereign debt crisis, they passed 5 percentage points.

Even as some investors have unloaded government bonds and bank shares, others are sticking to their guns and staying invested, citing improved economic and financial fundamentals.

Marc Stacey, a credit fund manager at BlueBay Asset Management said it would be a mistake to turn bearish on the Italian banks, noting their improved profitability and asset quality. All the same, Mr. Stacey added, he has recently bought credit default swaps to hedge against the risk of a further deterioration.

The FTSE Italy Banks index is still up 2% for the year, but was up 16% as recently as late April, tumbling as government bond yields have risen.

"We continue to hold UniCredit which we believe is an attractively valued bank experiencing a return to growth after restructuring," said Lewis Grant, equity portfolio manager at Hermès Investment Management, who added that it was too early to say whether recent volatility reflected sentiment alone or a shift in fundamentals.

A major issue is whether the incoming government will sully Italy's relations with European institutions. Italy's government bonds are still heavily dependent on support from the European Central Bank's bond purchases, and the country's wider financial system is more closely linked to government debt markets than in much of the rest of Europe.

Sentiment toward those government bonds has turned so quickly that liquidity for some Italian debt in the interbank market disappeared briefly on Monday, according to a government bond trader working for an Italian bank.

A sale of around EUR250 million ($295 million) to EUR300 million in Italian government bonds --a large but not unusual quantity -- left prices for the majority of bonds with longer maturities unavailable for between five and 10 minutes. An inability to find price quotes was a common phenomenon in 2011 and 2012, according to the trader, but had ceased to happen in recent years.

The ECB's rules allow it to buy government bonds as long as the country has an investment-grade credit rating. Italy's credit ratings with Standard & Poor's, Moody's and Fitch are each two grades above junk territory.

"With the ratings firms, it would be a big political call for them to junk Italy but it's a real risk. That would have knock-on implications for Italian banks and corporates," said AXA Investment Management's Mr. Iggo.

ECB purchases have made Italian government bonds less dependent on international capital, according to Cedric Gemehl, Europe analyst at Gavekal Research. Nonresidents now hold 32% of Italy's government debt, close to the lowest levels since the financial crisis began in 2008.

For the country's financial firms, the health of the Italian government bond market is paramount. Such debt made up around 8.5% of the assets held by the country's banks in February, compared with 3.5% for the euro area more generally.

"A debt restructuring would just kill the Italian banks. Even a 10% haircut on the bonds would cripple the system," said Dhaval Joshi, chief European investment strategist at BCA Research.

Isabelle Vic-Philippe, head of euro rates and inflation at Amundi Asset Management, said: "The link between banks and the sovereign is weaker than it used to be, but it's still there."

The size of the Italian financial system is also a concern to investors.

"It's not like Portugal or Greece," Ms. Vic-Philippe said. "Italy is a big country, and it's too big a risk."

She also said that the firm had closed its long position on Italian government bonds after the country's election, because of the perceived complacency of the market, but now has a small tactical long position on the market.

Write to Mike Bird at Mike.Bird@wsj.com

(END) Dow Jones Newswires

May 22, 2018 13:11 ET (17:11 GMT)