Cautious secondary confidence
Volatility may have returned in 2018 but trading markets have largely avoided panic or wild swings. Investors share their views on what this says about secondary-market mechanics.
REZNICK In a way, there are almost two markets. There is a smattering of smaller, less-liquid, small-cap names that don’t really trade at all. We tend to gravitate towards large-cap structures with sufficient liquidity for banks to hedge the risk through single-name credit default swaps (CDS).
Liquidity is generally healthy for large, liquid names and frequent issuers with or without single-name CDS. What is interesting is that, during pockets of volatility, implied volatility has spiked but realised volatility hasn’t. This is because there is a recognition that volatility is rate- or equity-led rather than credit-led, and the macro backdrop seems fairly sanguine.
In this environment, investors are less inclined to part with securities they like, because they can’t get them back. This is despite volatility spiking more often than last year, and perhaps by investors managing pockets of risk through CDS.
Things have evolved a little. We have seen substantial high-yield outflows in the US and a meaningful level in Europe. Investment-grade is more balanced but the technicals will have a substantial effect, particularly taking into account the 300 basis point real cost in the front end of the curve, as well as the hedging cost, to invest in the US.
These kinds of technical factors did not exist in 2017, but they do now. As a buyer, you can’t sell the market in size so you have to be more careful around exactly how and where in the curve you want to allocate your credit risk.
In this environment investors are less inclined to part with securities they like, because they can't get them back. This is despite volatility spiking more often than last year, and perhaps by investors managing pockets of risk through CDS.
EELES Echoing the liquidity component, where we have seen volatility has been in the most liquid elements. As Mitch Reznick points out, and it is very true for our opportunity set, we don’t want to sell our bonds because it can be challenging to buy them back.
As an impact-focused investor, the bonds we hold tend to be smaller than the average size from the same issuers but they have also tended to outperform during bouts of volatility and underperform when stability returns. This may only be by a basis point or two, but it shows that where investors are trading is in large, liquid lines they know they can transact in again.
Banks are clearly more balance-sheet constrained than they were. However, our opportunity set is in an area where issuance volume has been high – one of the benefits of which for issuers is access to an increased demand pool
