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.