Chasing yield: Bond liquidity in a post-crisis world
There has been no shortage of press coverage on financial market liquidity in recent months, with at least three examples of asset managers experiencing difficulties with the management of mutual funds that have had exposure to illiquid assets.
Of course, since the financial crisis, the market backdrop – and how liquidity is viewed – has altered significantly. Regulatory changes, such as increased capital requirements as well as macro-economic factors, among others, have all impacted secondary bond market liquidity.
As a result, over the past decade, banks and asset managers, as well as other players, have had to adapt their business models and risk management frameworks.
The challenge in today’s world is to maintain a sufficient level of liquidity in portfolios to meet potential client redemptions in all market conditions. This is particularly important as the bulk of mutual funds offer daily liquidity to their clients.
The bond market is far from homogenous. Bonds can be either public or privately issued and there is a wide range of issuers including governments, semi-government agencies, supra-national entities, corporations, banks and special purpose vehicles. In addition, the market covers a wide range of credit-worthiness from gilt-edged triple A issues to unrated bonds carrying a high credit risk premium.
There is clearly also a wide spread of maturities, of currency of issue, and importantly size. Smaller issues tend to be less liquid than bonds issued by larger borrowers but not all fixed income is structured the same way. The most liquid bonds tend to be bullet issues, where the principal value is paid in full when the bond matures, with a fixed coupon. Once you move into bonds with more complex structures, such as those that include embedded options and ratings tranches or have potential to convert into equities, then liquidity tends to diminish.
Here the investor base must also be considered. Bonds that appeal to the broadest investment universe will be the most liquid. Small issues with only a few holders and some element of structuring will tend to be less so. But conditions also vary through time and across sectors – government bonds, for instance, tend to be more liquid than high yielding corporate bonds.
Adapt to survive
We believe it is vital for investors to distinguish between overall bond market liquidity and that of individual securities. These days, overall, the market tends to function relatively well, with few liquidity problems. That’s partly because market participants have had to adapt their business models – asset managers don’t expect to be able to trade large sizes, frequently, at tight prices.
Many fixed income strategies have lower turnover than was the case in the past. Buy and Maintain fixed income strategies, for example, are designed to avoid liquidity issues by precisely structuring the maturity allocation of the bonds they hold, and generally holding the investments until maturity.
Tellingly, much of the recent media scrum has been less focused on market liquidity but on the question of holding less liquid assets in portfolios, which are designed to be liquid by providing daily dealing to their investors. And a liquidity mismatch can be the Achilles heel of an asset management business.
Investors could lose confidence in a manager’s ability to meet their own liquidity requirements through an inability to dispose of assets held in the fund in a timely manner and at an economically viable price. As history has highlighted, liquidity concerns can very quickly turn into a run on assets and the suspension of dealing in mutual funds.
It is understandable that some fund managers can be tempted to invest in less liquid securities, to secure higher yields and a perceived level of diversification. By doing so they are attempting to access a so-called liquidity premium – a return that is higher than the market as compensation for giving up a certain amount of portfolio liquidity. Most bond portfolios will have a range of liquidity exposures, reflecting allocations across credit ratings, maturities and issuers.
But the danger is that the temptation to push a strategy’s yield higher can overwhelm a manager’s ability to deal with redemptions, especially if they come thick and fast. The risk to a portfolio is that it either ends up with a higher proportion of illiquid assets, as more liquid holdings are sold to meet cash redemptions, or it ultimately performs badly as illiquid assets need to endure a fire-sale.
Market liquidity vs. portfolio liquidity
Market liquidity and the performance of strategies which have exposure to illiquid assets could become an issue if markets become more stressed. The picture in the fixed income market today is one of relatively low volatility and falling yields.
Default rates in high yield – both in bonds and loans – remain very low and I expect that central banks will likely become more accommodative from a liquidity point of view. As such, I believe that overall liquidity conditions should potentially remain relatively benign.
However, illiquid securities exist and the temptation in this low-yield environment to try and exploit that illiquidity premium, to boost overall returns, may remain for many. But when stress levels rise, monetising that risk premium could become ever-more challenging. We are strong believers in diversification in fixed income funds and work closely with our portfolio engineers and risk teams to ensure that liquidity is well managed.
For open-ended fixed income funds, it is our belief that maintaining liquidity in well-managed and diversified strategies is the best way to serve clients over the long term.
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