Bondholders in Europe just got a wakeup call.
After a four-month rally in euro-region debt, yields on Italian and Spanish bonds had their biggest one-day jump in almost a year last week as a selloff that started in Greece spread. With bids evaporating and prices sliding, traders poured into derivatives as they rushed to protect against losses. Italy’s and Spain’s bonds extended that slump today.
Even with borrowing costs from Ireland to Italy near record lows, the sudden price swing shows they’re not immune to the bouts of volatility that characterized the four-year debt crisis. The risk is that speculative traders, who bought debt on the assumption the European Central Bank would support the market, may try to flee at the same time if the outlook darkens.
“You only know how wide the door to the exit is when there are a few of you trying to push through at the same time,” Michael Riddell, a London-based fund manager at M&G Group Plc, which oversees the equivalent of $417 billion, said on May 16. “I don’t think liquidity has been that great in peripherals at any stage.”
Greece’s 2 percent bond maturing in February 2024 dropped 3.095, or 30.95 euros per 1,000-euro ($1,373) face amount, to 75.3 on May 15, the biggest outright decline in price since the securities were issued in March 2012.
Yields on the 10-year debt surged 51 basis points, or 0.51 percentage point, to 6.81 percent, the biggest jump since June 2013. They extended the move the following day to leave the rate at 6.86 percent at the end of last week, the highest close since March 27.
Prices plunged in the wake of opinion polls suggesting the nation’s governing coalition was losing support before local-government votes and European Parliament elections on May 25.
Prime Minister Antonis Samaras’s coalition partner Pasok, which dominated Greece’s politics for three decades, was ranked sixth in a poll with 5.5 percent as voters blamed the party for the country’s economic meltdown. The first round of local and regional elections in Greece ended yesterday with no single party winning enough support to declare a decisive victory.
In Italy, Prime Minister Matteo Renzi’s party is facing its first elections since coming to power three months ago, risking a voter backlash amid a sluggish economy and a corruption scandal in Milan.
Small Sales, Big Impact
As contagion spread on May 15, Italy’s 10-year yield, which touched a record low earlier that day, rose 19 basis points to 3.10 percent. That’s the biggest increase since June 24.
The yield on the securities climbed nine basis points to 3.15 percent at 3:41 p.m. London time today and the rate on similar-maturity Spanish bonds increased six basis points to 3.01 percent. The yield on Greek 10-year debt dropped eight basis points to 6.78 percent.
“Just a small wave of sales is enough to have a large impact on prices” for Greek securities, said Alessandro Giansanti, a fixed-income strategist at ING Groep NV in Amsterdam. “A dry-up in liquidity happens every time there is a re-elevation of credit risk in low-rated bonds. The market was substantially overweight on peripheral countries and this has amplified the movement.”
An overweight position means an investor holds a bigger percentage of the debt than is contained in the indexes used to measure performance.
Spain’s 10-year bonds joined the May 15 selloff, with yields rising 16 basis points that day to 3.02 percent. While that’s the biggest increase since June 24, a move of that size wouldn’t have been in the top 20 largest increases in 2012.
That’s a sign of how much the euro-area markets have calmed amid a rally sparked by ECB President Mario Draghi’s assertion in July 2012 that he’d do whatever was necessary to hold the currency bloc together. Encouraged by signs of an economic recovery, Ireland, Portugal and Greece have returned to bond markets after receiving international aid. The prospect of additional ECB stimulus, including potential purchases of debt, is helping to propel prices higher still.
The extra yield investors get for holding Spain’s 10-year bonds instead of similar-maturity German debt increased five basis points to 167 basis points today, after touching 179 basis points on May 16, the most since March 17. Even so, that’s down from 222 basis points at the end of last year, and almost 650 basis points in July 2012.
“Our initial assessment is that the peripheral spread widening reflects short-term positioning issues rather than a more substantial rethink on euro sovereign spread risk,” Morgan Stanley analysts including London-based Anthony O’Brien wrote in a May 16 client note.
Investors were prompted to turn to the derivatives market instead of trading cash securities last week. Volume on the front Italian BTP bond future jumped to a record of about 165,000 contracts on May 15.
“Prices started to drop quickly and suddenly there was a rush for the exit or a rush to hedge via the futures,” said Peter Chatwell, a fixed-income strategist at Credit Agricole SA’s corporate and investment banking unit in London. The derivatives are “the most convenient instrument if you need to change your position quickly,” he said.
In a further sign of reduced market liquidity, the difference between bids and offers on the Greek 10-year securities increased to as much as 17 basis points during the May 15 selloff, compared with an average 12 basis points in the previous 28 days, according to data compiled by Bloomberg. The spread stayed at around 15 basis points the following day.
German 10-year bunds, Europe’s benchmark government securities, had a spread of less than half a basis point between bids and offers last week.
The potential for ECB stimulus will continue to draw investors into peripheral bonds and cause yields to fall relative to benchmark securities, according to Norbert Aul, a European rates strategist at Nomura International Plc in London.
Even so, events last week show “spread compression in the periphery is not a one-way street,” he said. “The magnitude on a pullback is amplified when liquidity is drying up.”