Defining the term ‘liquidity’ can prove to be rather onerous as it can apply to a several different concepts. More often than not, the term is usually used in conjunction with the market, where market liquidity refers to the ability of the market to facilitate a purchase or sale of an asset without shifting the price of that asset. Market liquidity is usually impacted through technical market conditions alongside market structure and investor sentiment to a lesser extent. Central bank liquidity also has a role to play here. These banks can, and often do, provide liquidity through various asset purchasing programmes such as quantitative easing to inject any needed liquidity into markets.
Liquidity additionally plays a part in specific assets as opposed to the market in general. This brings about the notion of liquidity risk and premium. All assets lie on a scale from being highly liquid (typically consist of benchmark issued names) to highly illiquid (trades by appointment). As this is the case, investors must be better compensated for less liquid assets by the market and yield greater returns than assets with greater liquidity.
Liquidity also exists within a portfolio. The structure of the fund itself will have liquidity terms which in turn will affect how and when fund holders can redeem. This depends on the fund structure (whether it is an open-end, closed-end, hedge fund etc.) or indeed the redemption requirements (notice periods, liquidity gates or redemption charges). The liquidity of the underlying securities within the portfolio will also impact the overall liquidity of the fund itself. This gives way to redemption risk where a fund may struggle to meet redemption demands because of the illiquid nature of the underlying assets.
In recent years liquidity has hit the fixed income space hard. Liquidity has appeared to have tightened in bond markets as spreads have widened in a number of asset classes including, but not limited to, high yield and emerging market debt. What is even more problematic is that we are now seeing a bifurcation of liquidity, where liquidity is increasingly concentrated in assets with the highest liquidity and falling in assets of the lowest liquidity.
To start, it is the central bankers that have resorted to extreme measures to maintain low rates and this in turn has resulted in primary debt issuance to rise significantly, especially in corporate bond issuance as companies seek to take advantage of borrowing at record low rates. These are resulting in the demand of liquidity to increase but the problem arises because of the accompanying reduction in the dealer’s ability to provide that liquidity because of a number of rules and regulation imposed post-crisis limiting their trading inventories.
Whilst primary issuance has excelled, secondary markets are seeing less turnover post-crisis. Though market participants are still able to, for the most part, execute any trades as and when they require, the time and hassle involved has risen, making trading more difficult in these areas. This is a trend that is expected to continue as trading volumes become smaller and their ratio to market size falls (turnover ratio). Also, as evidenced by significantly reduced transaction sizes, fixed income markets are declining in depth and this is resulting to smaller transactions to shift market pricing to a larger extent than previously.
This is resulting in greater volatility in market pricing and what’s even more concerning is that a lack of liquidity has the potential to spark the next financial crisis.
What should you be doing?
Throughout the asset management industry, liquidity is a significant factor that must be managed accordingly. There are a number of good practices on liquidity management and oversight that investors must make sure their asset managers are adhering to, to ensure liquidity doesn’t harm their performance portfolios. For example, it is important to make sure an asset manager and their fund can handle multiple redemptions, so there should be arrangements in place to ensure that redemptions can be met over the full life cycle of the fund.
The asset managers must ensure they are constantly monitoring the liquidity of portfolio positions as they can change significantly in different periods or depending on market environment or investment sentiment, especially for positions that may be difficult to assess liquidity due to the infrequent trading nature of the security. By association, investment managers can also define liquidity buckets to indicate which securities have high liquidity or low liquidity and then set limits in the overall positioning within these buckets, monitoring the limits and changing accordingly depending on markets.
Further, it is encouraging for an asset manager to have independent risk functions that are able to solely monitor portfolio positioning in any liquidity buckets, if in place, or the liquidity of individual positions. These can then be passed onto the manager and if there is a breach in any limits or excessive risks, they can be addressed proactively. Alongside a risk function, stress testing is vital for fund managers to assess the impacts of a number of different scenarios (what the market expects to extreme circumstances or even the effects of another financial crash) on the portfolio and the associated liquidity risks.
Because of the market environment we now live in, liquidity, specifically in fixed income, is a very timely issue for investors and it is more important than ever to make sure the asset managers you have allocations with are managing that liquidity, or lack of it, appropriately.