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Fixed income

How’s Liquidity?

Ben Edwards |22-Jul-2016

 

Diminishing liquidity should encourage investors to extend their potential holding period and to focus on longer term fundamentals.

 


As a fixed income fund manager it’s a question I’ve been asked a lot over the last five years. It’s the question investors have to ask but I think they’d prefer it if I could just give them a number out of 10. Unfortunately it’s seldom that simple.

We all now appreciate that liquidity has undergone a structural decline since the financial crisis. Regulators have made holding assets to facilitate secondary trading significantly more expensive for banks – a necessary price for a more stable financial system, they believe. Dealer inventory in US dollar corporate bonds as a percentage of bonds outstanding may be as much as five times lower than it was in 2007. But does it really matter?

One of the more sensible comments on liquidity, is that it’s never there when you really need it. If we were to enter a risk off scenario, it’s far more important what bonds you choose to own going into it than what you may or may not be able to change when you’re in the eye of the storm. Ultimately, that’s our job as portfolio managers. Being confident in the companies we lend money to, on behalf of clients, in the good times is easy, but knowing they will make it through the difficult times is less so, but that has to be the goal.

New buyers, new sellers

The market has changed and continues to do so. The largest buyer of government bonds since the crisis has been global central banks. Since June this year, the European Central Bank included corporate bonds in its monetary easing programme. This deep and relatively price agnostic bid has certainly provided one-way liquidity in certain segments of the fixed income market. Since the UK’s EU referendum, the possibility of the Bank of England buying of sterling corporate bonds has re-entered investors’ imaginations.

There’s still plenty of bonds to buy as well. Global companies, particularly high quality companies have continued to take advantage of low global bond yields to borrow for longer, borrow for acquisitions, borrow to defer tax and borrow more. Much of the S&P 500’s performance in 2014/15 can be attributed to debt funded dividends and share buybacks. The primary markets can offer an attractive entry at little cost, in a world that still craves yield – but selectivity is becoming increasingly important.

Liquidity is challenging but it’s also not the worst risk to be paid for. Historically, investment grade credit spreads more than compensate investors for potential defaults. The additional premium for owning corporate versus government bonds is down to volatility and liquidity. These risks can be managed at a portfolio level, with investors benefiting from the illiquidity premium in certain assets while maintaining a liquidity buffer in cash and gilts.

Ultimately, it’s more complicated than a single number out of 10. It’s about having confidence that positions can be held through the investing horizon or that marginal positions can be exited quickly and cheaply. Liquidity is not what it once was - size matters. Selling or buying a small amount of securities is far easier than dealing with an amount of significant size. New liquidity is being created on both the bid and offer side of the market but it is unbalanced and temporary. Positioning to benefit from this rapidly evolving investing environment goes a long way to ensuring clients can benefit from illiquidity not just suffer from it.