By Paul J. Davies and Anna Hirtenstein

Italian government bonds rallied as investors cheered the news that former European Central Bank President Mario Draghi had been asked to form a new government.

The gap between yields on 10-year Italian bonds and their German equivalents fell to the tightest level in nearly five years, at 1.027 percentage points, according to Tradeweb. Yields fall when bond prices rise. Italy's stock market also rallied, with the FTSE MIB benchmark up 2.6%.

Italy's coalition government collapsed in January over arguments about how to spend European Union funding meant to spur the recovery from the Covid-19 pandemic. Mr. Draghi, who was credited as ECB chief with saving the eurozone from its political and financial crisis in 2012, is seen by investors as a safe, technocratic leader capable of helping Italy out of its worst recession since World War II.

The market reaction suggests investors think Mr. Draghi can govern for a while and enact reforms, said Sebastien Galy, a macro strategist at Nordea Asset Management. But there are no guarantees.

"Should he fail to form a government, a snap election would be called, and the odds are still moderate that this will happen given the fractious nature of Italian politics," Mr. Galy said.

Italy has one of the highest levels of public debt among developed countries, which has long prompted concerns about its ability to repay lenders while hitting the EU's targets for financial discipline. General government debt peaked to more than 150% of gross domestic product in 2020, according to data from Macrobond Financial, due to the extra spending and economic slowdown caused by the Covid-19 crisis.

A big expansion of the ECB's bond-buying program under its new president, Christine Lagarde, has helped keep bond yields low in Italy and elsewhere. That is despite early worries among investors over whether Ms. Lagarde would continue to support Italy as Mr. Draghi had done.

One of the first big steps for a new Italian government would be to decide how to spend the EUR200 billion, equivalent to $240 billion, in emergency funding from the EU. It has an April deadline to present its strategy to Brussels.

A Draghi-led government would be more friendly toward the EU and would likely put experts in major roles to steer a crisis-recovery strategy, said Citigroup banking analyst Azzurra Guelfi.

"He has an internationally high profile, with a proven track record of managing critical situations, as well as a deep understanding of the key issues for Italy and its banking sector," Ms. Guelfi said.

Italian 10-year yields fell to 0.548%, while German 10-year yields rose to minus 0.479%.

In the U.S., benchmark 10-year Treasury yields rose to 1.113%.

Write to Paul J. Davies at paul.davies@wsj.com and Anna Hirtenstein at anna.hirtenstein@wsj.com

(END) Dow Jones Newswires

02-03-21 0820ET