You could say liquidity is like good health – you don’t appreciate it until your doctor is your new best friend.
While market risk can be easily judged by price fluctuation – and we’ve had to do such explaining in recent months – liquidity risk isn’t always felt until you go to sell. Put simply, liquidity for bond investors is the ability to sell at a reasonable price within a reasonable time frame. If one investor can’t sell, there’s usually others. Crises occur quickly, with an avalanche of price drops triggering more selling … and then further price drops.
Before such a domino effect cascades through the fixed-income markets, you should understand how we got here, what a crisis might look like, and strategies to avoid potential loss in the “safe” portion of portfolios.
More risk now sits with investors
Before 2008, even the most esoteric bonds could be sold relatively easily. Big investment banks acted as principals responsible for lining up buyers and sellers. These “too-big-to-fail” institutions held massive inventories of bonds and loans, which helped keep prices in check. Now, post-crisis regulations have reduced banks’ ability to warehouse the risk that once promoted the orderly trading of credit markets.
That’s a big deal within a semi-liquid asset class. Bonds and loans aren’t exchange traded like stocks. Instead bonds and loans are traded over-the-counter in a brokered market. As a result, the liquidity risk has moved from the balance sheets of investment banks to portfolios of individual investors.
This new market’s stress tests
While past performance does not equal future results, there are several recent guides to help predict a reaction. Both the Taper Tantrum of 2013 and Flash Crash of 2014 caused a significant down draft on fixed-income markets. In 2013, Federal Reserve chairman Ben Bernanke announced that the Fed would end quantitative easing, causing market hysteria. Then, in 2014, U.S. Treasuries experienced one of the largest intraday changes in yields, larger even than the decline prompted by Lehman Brothers filing for bankruptcy (September 15, 2008). Both illustrate that market shocks easily “flash” when liquidity is low. Investors can no longer rely on dealers to provide liquidity in volatile markets.
Is a liquidity crisis hiding in plain sight?
Let’s fast forward to last month, when investors pulled $2.2 billion from all loan mutual funds and ETFs in just a four-day window.1 Amidst fears of an economic slowdown, from mid-November to mid-December, withdrawals from the asset class reached almost $9 billion. Bloomberg noted that Lord, Abbett & Co. and Eaton Vance Management were among the fund managers selling holdings to meet redemption requests.
It doesn’t matter if the market was rational – and we’d argue that December’s job reports emphatically says it was the exact opposite. Panic is not liquidity’s friend. Take a look at the following three charts to illustrate the net asset value deterioration possible when a liquid fund is forced to sell illiquid underlying holdings at a loss into a panicked market. Asset sales may cause liquidity issues, which may further impact asset prices.
NAV deterioration vs. NAV noise
Interval funds offer a potential solution to avoid principal erosion in this environment. Many fixed-income interval funds mark their loans and bonds to the market, but thanks to their quarterly liquidity feature, they can typically hold on to these investments in this environment. Experienced fund managers can block out the noise and strategically buy at a discount instead of selling at one.