Italian lessons

Futures market and dealer engagement were both concerns during this year’s volatility, reports Dan Barnes.

The tension between Italy’s government and the European Commission has seen bond yields rising, and market liquidity suffering. Although ripples are already spreading across the rest of the Eurozone, if yields hit 4%, some analysts believe contagion will hit the region in earnest.

The massive sell-off in the market at the end of May was followed by a drop in the bid to cover ratios for government debt.

“People were shocked by what happened in Italy,” says Vincenzo Vedda, head of trading at DWS. “If a 30-year blows up, okay, but when a two-year bond on the run blows up the rules change.”

When the market turned on Italian debt, it was no surprise that bank coverage declined, given the existing challenges they have in holding capital against risky and volatile assets.

“Why would an investment bank want to hold Italian government debt on a proprietary basis, if they think they are going to risk a large amount of capital against it?” notes Bryn Jones, head of fixed income at Rathbones. “If you look in the Italian credit markets, [banks] will only hold the top-most liquid assets as part of their proprietary books. A lot of that is driven by regulation and also by risk appetites.”

However the extent to which liquidity dried up was a concern say traders, with the thin futures market exacerbating volatility and making it hard for banks to put big positions on. From the buy-side perspective, traders have observed that market structure has not been optimal.

“It is such a big shame that the Italian bond market has such an inadequate futures market,” says Hans Bayer, chief dealer at NNIP. “It has been driven by headline risk being so huge.”

Vedda adds, “The interesting piece of what happened on the 29th May was that the futures market was driving the cash market. Even though in nominal terms, the cash market is much bigger than the futures market.”

At a practical level, asset managers will need to consider how to approach investment in the market, including a commitment of greater resources in order to reinforce certainty around both trading and investment decisions.

“On the credit side you have to employ a lot more people to do the credit work so that you know if you are going to buy it you are going to hold it,” notes Jones.

“Buy and hold strategies become much more important than trading strategies so the portfolio manager has to be conscious of that and you have got to demand a liquidity premium; if you are going to get assets that are illiquid you are going to demand a higher yield.”

Negotiations with issuers and sell-side firms will also be necessary if a firm is to manage risk effectively.

“There are controls that you can put in place as a buy-side manager to ensure that you are going to get the liquidity and the yield you require should you need to exit the position,” Jones says.

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