By Antonella Cinelli and Valentina Consiglio
ROME (Reuters) - Italy's uncharacteristic political stability is likely to boost its government bonds next year, analysts say, as uncertainty over Germany and France undermines investor confidence in them.
While most of the risks that have made Italian bonds the euro zone's highest-yielding remain, markets are focused for now on the opportunities Rome's 2.5-trillion-euro ($2.62 trillion) debt market, one of the world's biggest, has to offer.
Although the euro zone's third-largest economy has ground to a halt and its debt pile - the second largest in the currency bloc - is forecast to rise further through 2026, for many investors French and German strife appears more immediate.
"Italy is no longer considered the sick man of Europe," said Christopher Dembik, senior investment adviser at Pictet AM.
As long as that view prevails, Italy will enjoy lower debt costs. The stakes are high, with Rome likely to sell 300 billion to 310 billion euros of medium- and long-term bonds next year.
The yield gap between Italy's benchmark BTPs and German Bunds narrowed this month to a more than three-year low. And with Germany near recession, bond specialists expect this trend to continue and perhaps accelerate.
Markets also view Italy's relatively high-yielding BTPs as an attractive alternative to French OATs, as Paris grapples with budgetary and political upheavals.
Japanese investors in particular are now switching from French to Italian debt, Dembik said.
RISKS
Italy's government is under EU orders to slash its deficit, but markets see the curbs planned by Prime Minister Giorgia Meloni, firmly in power after two years in office, as more convincing than the chaos in France.
With yield spreads tightening across the euro zone, Althea Spinozzi, head of fixed income strategy at Saxo Bank, said a previously "unthinkable" narrowing of the BTP-Bund spread to zero was now possible.
However, headwinds could knock such a scenario off course.
Italy's weakening economy could undermine its promised fiscal consolidation, diminishing yields due to ECB rate cuts might make Italian paper less attractive, or a return to global risk-off sentiment could hit BTPs.
Another risk is France itself, Aymeric Guedy, co-manager of French asset management firm Carmignac, told Reuters.
"So far the French political and fiscal crisis has had no impact on broader European spreads, but if it accelerates and turns into a financial crisis then BTPs will not be immune," Guedy said.