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08 Mars 2017

A very good time to revisit the taper tantrum

Among all the risks which could derail the current steady state of European credit markets, a major rate selloff ranks high on the list of many investors including ours. As we have explained in this letter on many occasions, we are no rate markets experts and thus are not making predictions that such event will occur any time soon or not. We are simply stating the obvious; (i) the probability of a rise in yields is higher now that the economy is stronger and is gaining more momentum, and (ii) given the historically low rate levels, any spike in yields would be incredibly damaging to the performance in many segments of the fixed income markets. As credit investors, we have made significant adjustments to our portfolio construction over the past few quarters in order to reduce the vulnerability of the portfolio to such an event – see our November 2016 letter for more analysis on this point. In this context, we think that it is also useful to revisit the price action in credit markets during the 2013 taper tantrum episode and its aftermath to identify certain risks and opportunities.

Some clear trends emerged from the tantrum

From the start of May 2013 to July 2013, 10-year US Treasuries yields rose by 110 bps, a 65% spike. Over 3 months, 10-year and 30-year US Treasuries returned an amazing -11% and -18%, respectively. As a reminder, the 10-year Bund yielded 0.21% at the end of February 2017, which implies that a similar rate movement could be even more damaging in today’s EZ. Importantly, the timing of the episode was extremely brutal and somewhat unexpected, which in turn created some broad-based volatility and blow-ups beyond the remit of the rates market. Although the selloff in credit markets was quite undifferentiated at first, there were some clear trends emerging once the dust settled.

To start, the reason for the selloff is always of a major importance. Although credit markets dropped significantly in the first two months of the tantrum – between -3% and -7% – it is worth noting that the price of some credit assets started to recover pretty quickly as rates stabilized. A key factor supporting this trend was the fact that rate volatility at the time was not driven by major inflation fears, but more by the expectation that the US economy had returned to a more normal growth path. Second, higher-quality assets underperformed the rest of the market, both on the way down and on the way up. A point in case was the IG market which experienced a max drawdown of -6.5% and was still down -5% more than 5 months after the start of the tantrum. In HY, a similar pattern occurred; the CCC bucket – which sold off in sympathy with the rest of credit markets at first – was back to positive returns 4 months after the start of the tantrum, supported by a higher carry, a set of more idiosyncratic stories and a higher correlation with equity markets. In contrast, the BB bucket was still down 2.5% at the start of Q4 2013.

This trend was also magnified by the duration factor, as there was a significant underperformance of longer duration assets – a market segment which can typically be tapped by higher-quality borrowers. Whereas the 0-4-year HY bucket had a max drawdown of -2% and was back to positive returns in 2.5 months, the 7-10-year bucket experienced a max drawdown of -6% and was still in the red by -3% more than 5 months later. Interestingly, leveraged loans were much more resilient than bonds during the selloff; their max drawdown was a mere -0.9%, recovering to positive returns after 2.5 months only, as the floating-rate feature of the instrument provided near-perfect protection to investors in such a market environment. Last trend worth noting, the larger and most liquid bonds underperformed the universe of smaller bonds – often not included in HY ETFs. The former experienced a max drawdown of -5% – twice larger than for the smaller bonds – and were still in negative territory more than 5 months after the start of the tantrum. This move reflects some exodus from “tourist” credit investors at the time, which were more concentrated in less credit intensive and more liquid vehicles with the goal to enhance their fixed income returns.

Consistent with what we learnt

Although history never repeats itself in financial markets, we believe that our current portfolio construction builds upon some of the most interesting lessons we drew from the taper tantrum period. Our focus on catalyst-driven situations and on low-duration/short-dated call instruments, some of our risk taking via CDS or floating-rate instruments, our negative view on European IG – to name a few – are all consistent with the potential upcoming sequel of the taper tantrum in 2017. Importantly, our current defensive positioning is even more crucial today in our view, as credit valuations are more stretched than they were in 2013.

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