The Daily Update - Paying the Price for Volatility

Holders of Italian 2-year debt brought new meaning to the idea of “paying the price for volatility” given that (until a fortnight ago) they actually prepaid – in negative yields – for the privilege of exposure to Italian market risks. In May alone, Italian short term yields went from -0.15% to close yesterday at 2.70%; 185bps of this 285bps move occurred yesterday. This was unprecedented and equates to 18 standard deviations beyond the average daily move over the past decade (which itself was quite high during the Eurozone Crisis of 2011/12).

Today, mercifully, the Italian curve has retraced some of yesterday’s blow-out. Even a scheduled auction of 5/7/10 year debt didn’t dampen this, attracting a respectable cover of 1.48 times, perhaps demonstrating some major European banks’ and institutions’ hopes of an “ever closer union” and expectations that further EU support will eventually be offered (and accepted). Many still see an Italy default as unlikely given the major holders of its debt include so many vital parties from French and German banks to the Italian populous themselves making it a highly unpopular move for the Government no matter how maverick they seem.

But yesterday’s moves are instructive as to the often underestimated risks of short-term debt from both a default and recessionary risk perspective. In price action terms, the 30-year fell -4.45% vs -3.65% for the 2-year. This comparative loss of 1.2x seems quite understated given that the 18-year duration of the long bond is more than 9x that of the 2-year. It shows we do not live in a “Parallel Bond Universe” and that measuring bond risk in terms of modified duration, assuming a parallel shift in the yield curve, is inadequate (equivalently the 30-year would have lost a third of its value yesterday in a parallel shift).

When one maps out the entire life cycle one sees yields shift over time: from a normal positively sloped yield curve to a heavily inverted one. Crises don’t happen very often and those who have not witnessed one are always surprised how much short dated bonds can suffer. The recent Italian experience clearly shows that it’s not the duration of a bond that matters most, the more important factor is whether the market perceives a country as being creditworthy. If you want to hold short dated bonds, you need to make sure they are issued by the most creditworthy nations.

Please read this important information before proceeding. It contains legal and regulatory notices relevant to the information on this site.

This website provides information about Stratton Street Capital LLP ("Stratton Street"). Stratton Street is authorised and regulated by the UK's Financial Conduct Authority. The content of this website has been prepared by Stratton Street from its records and is believed to be accurate but we do not accept any liability or responsibility in respect of the information of any views expressed herein. The information, material and content provided in the pages of this website may be changed at any time by us. Information on this website may be out of date and may not be updated or removed.

The website is provided for the main purpose of providing generic information on Stratton Street and on our investment philosophy for the use of financial professionals in the United Kingdom that qualify as Professional Clients or Eligible Counterparties under the rules of the United Kingdom Financial Conduct Authority (the "FCA"). The information in this website is not intended for the use of and should not be relied on by any person who would qualify as a Retail Client. Products and services referred to on this website are offered only at times when, and in jurisdictions where, they may be lawfully offered. The information on this website is not directed to any person in the United States. The provision of the information on this website does not constitute an offer to purchase securities to any person in the United States (other than a professional fiduciary acting for the account of a non-U.S person) or to any U.S. person as such term is defined under the Securities Act of 1933, as amended.

The website is not intended to offer investors the opportunity to invest in any Alternative Investment Fund ("AIF") product. The AIFs managed by Stratton Street are not being marketed in the European Economic Area ("EEA") and any eligible potential investor from the EEA who wishes to obtain information on the AIFs will only be provided with materials upon receipt by Stratton Street of an appropriate reverse solicitation request in accordance with the requirements of the EU Alternative Investment Fund Managers Directive ("AIFMD") and national law in their home jurisdiction. By proceeding you confirm that you are not accessing this website in the context of a potential investment by an EEA investor in the AIFs managed by Stratton Street and that you have read, understood and agree to these terms.

No information contained in this website should be deemed to constitute the provision of financial, investment or other professional advice in any way. The website should not be relied upon as including sufficient information to support any investment decision. If you are in doubt as to the appropriate course of action we recommend that you consult your own independent financial adviser, stockbroker, solicitor, accountant or other professional adviser. Past performance is not necessarily a guide to the future. The value of investments and the income from them may go down as well as up. An application for any investment or service referred to on this site may only be made on the basis of the offer document, key features, prospectus or other applicable terms relating to the specific investment or service.

Where we provide hypertext links to other locations on the Internet, we do so for information purposes only. We are not responsible for the content of any other websites or pages linked to or linking to this website. We have not verified the content of any such websites. Such websites may contain products and services that are not authorised in your jurisdiction. Following links to any other websites or pages shall be at your own risk and we shall not be responsible or liable for any damages or in other way in connection with linking.

By using this site, you should be aware that we may disclose any information that we hold about you to any regulatory authority to which we are subject, or to any person legally empowered to require such information.

This website uses cookies to improve user experience, by clicking the "I Accept" button below means you consent to the use of cookies on our website.