Investors can hardly have failed to notice the increase of volatility across various assets. The chart below is but one example, showing the yield of subordinated investment grade bonds within Europe (the chart is a weekly candlestick chart where a clear box shows yields rose on the week and a dark box that yields rallied).
A cursory glance shows that this asset class was strong at the start of the year then widened into the equity weakness observed in February, followed by further volatility and increasing yields as concerns over Italy swirl around the market.
Source: ICE BAML indices, Bloomberg, Fidelity International 22 June 2018.
Although the ECB skilfully managed the messaging about the tapering of quantitative easing and forward guidance about future interest rates moves, the market relief has been relatively short lived as Italian assets have weakened post a small rally after the ECB meeting.
A particularly pernicious aspect of European investment grade markets is the dearth of liquidity. This has been a market feature for quite some time and each bout of volatility reminds investors that this aspect of the market amplifies and extenuates the moves. Relatively small selling flows can and do cause big gaps downwards in prices as dealers are reluctant or unable to warehouse the risk and so lay off any bonds to other dealers while prices correct to clear that small selling pressure. In a similar fashion, small buys are generally met with a lack of dealer inventory and so dealers are forced to look for those bonds and bid up prices in order to accommodate the investor needs.
The net effect of this market feature is three-fold: firstly, bond prices are generally volatile and can widen quite dramatically; secondly, dealers tend to increase the difference between buying and selling prices to reflect the lack of liquidity; and thirdly, the illiquidity means it is quite difficult to add to positions at cheaper prices since the bonds are not available even though prices are lower. It is also unrealistic to sell bonds into the market as prices are generally not representative and uneconomic.
Positive outlook on credit
Longer term investors have experienced this phenomenon many times in the past. Through maintaining a core of very high conviction positions in a portfolio and letting the passage of time cushion some of the short-term price volatility, investors have generally been well rewarded. Through buying securities with substantially more income generating characteristics than negatively yielding government bonds, investors with longer term horizons will benefit as that income accrues with the passing of time.
The key is having the analysis and depth of research that enables a high conviction to be established over the various holdings and then to exploit any market weakness or dislocations to bolster those positions.
Since my medium term view remains constructive over the prospects for the European and global economies, even with the headwinds of potential trade skirmishes and Italian uncertainty, I continue to prefer credit over European government bonds. And despite the recent uncertainty causing a degree of downward price volatility, the prospects for European investment grade credit returns remain positive as the income gently accrues with the passage of time.
Keep calm and keep clipping those coupons!
