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Exploring and Exploiting (Il)liquidity

Money is gushing through the global financial system thanks to years of central bank largesse. Yet trading liquidity has been on a downward slope. It has been getting harder and more expensive to transact in size.

What does this mean for investing and portfolio construction, and how should investors weigh the risks and opportunities? A group of 80 BlackRock investment professionals debated these questions at a recent gathering in London. Our 12-page publication attacks the topic from all angles, drawing on BlackRock’s unrivaled expertise in investing, risk and trading.

The 12-page piece is the second based on the London forum – and the third in a series of BII publications on trading liquidity.  It follows Setting New Standards of May 2013 and Got Liquidity? of September 2012.

Highlights of The Liquidity Challenge:

  • Market liquidity has declined since the 2008 financial crisis. The situation is challenging in U.S. corporate bonds—and more so in euro and sterling equivalents.
  • The decline in corporate bond market liquidity appears to have stabilized – and there are some (mild) signs of improvement.
  • Poor corporate bond market liquidity could at least temporarily worsen any market downturn, especially given stretched valuations.
  • Prices could gap down in case of a wave of reallocations out of corporate bonds – although the (super-sized) appetite for quality yield from insurance companies and other institutions is a stabilizer.
  • Investors prefer liquidity—and are prepared to pay a premium for liquid assets. The flip side: Less liquid assets tend to deliver superior returns in the long run.
  • In equity markets, other return factors such as value (versus growth) and momentum can overshadow liquidity or mitigate its effect. Illiquidity strategies require patience.
  • A long horizon and risk management are key in any strategy aimed at capturing the return premium from holding less liquid assets.
  • We propose a framework for scoring illiquid assets to guide a decision on whether to include them in a portfolio.
Ron Kahn (left) and Supurna Vedbrat (right)
Ron Kahn (left) and Supurna Vedbrat (right)
Kashif Riaz (left) and Richie Prager (right)
Kashif Riaz (left) and Richie Prager (right)

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