Market Extra: Here’s why Italian bonds rallied after Moody’s downgrade

A rating downgrade is usually a sobering occasion for bondholders, offering a judgment that a borrower is less creditworthy than previously believed.

So why did Italian bonds rally after Moody’s cut the country’s debt rating to one notch above “junk” late Friday?

To begin with, the move didn’t come out of the blue. Investors have been bracing for a downgrade, which has accounted in part for a selloff in Italian bonds that drove yields sharply higher since late August. Moreover, market participants say the bounceback in Italian government paper reflects how the ratings firm chose the least damning way of outlining its concerns over Italy’s proposed budget-busting deficit, which could violate the European Union’s fiscal rules.

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