Liquidity continues to be an ongoing concern for fixed income participants and market regulators globally. Recent high profile failures of funds run by Third Avenue Management, Stone Lion Capital Partners and Lucidus Capital Partners sparked somewhat of a panic, at least in credit markets. The main cause of these failures was that the funds offered a level of liquidity that was inappropriate for the often highly illiquid, distressed assets that they were buying.
In our view, it is time to reassess market attitudes towards liquidity. As an industry, and more broadly as investors, we need to better acknowledge that liquidity is not instantaneous, free and continuously available. Instead, we may have to start moving towards a model where investment horizons and liquidity expectations are more appropriately matched to the asset classes being invested in.
Fallacy of instant and cost-free liquidity
Despite the expectations of some market participants, it is not always possible to quickly and cheaply exit an asset class. Investors, borrowers, banks and asset consultants may need to adjust their expectations for what will be achievable in a more highly regulated market and one with a different level of liquidity than experienced over the past 20 years. One could argue that liquidity has always been variable, especially at times of high volatility; however, this is now likely to be more evident with the banks no longer being able to absorb large parcels of securities.
Potentially, liquidity can be improved, but it will require the various participants in the market to adjust their expectations. Issuers, for example, may need to more closely align their borrowing patterns with what investors require. This may mean shorter tenor deals, as well as smaller and more frequent issues to help facilitate better maturity profiles for their debt. It could also mean that corporate borrowers rely more on the banks for their funding requirements and that the banks need more frequent access to capital markets, significantly changing the diversity of investment opportunities in debt markets.
Institutional investors and asset managers may need to adjust the style of products they offer to their clients. For example, it may no longer be possible to offer daily liquidity to clients and redemption periods may need to be extended to weekly or monthly windows. Another option may be to adopt liquidity windows that allow redemption of a certain percentage of an investment, rather than the whole sum. Even if instant liquidity were possible, it is often not in the best interests of investors to achieve it at ‘fire sale’ prices.
For asset consultants and other investment gate keepers, this may mean accepting that large-scale changes in asset allocation, particularly in cash markets, may take longer to implement and incur significantly larger transaction costs than their current modelling suggests.
In our view, all participants need to have longer investment time horizons and to recognise that periods of volatility can provide an opportunity to add cheaply to portfolios, rather than being a signal for them to rush for the exit, while still expecting to do so at minimal cost. It may also mean that short-term allocations into low liquidity markets should have a higher-cost exit strategy allocated against any incremental pick-up in return.
Assuming no change in asset allocation practices or in the provision of very short redemption periods for investors, then asset managers may be forced to adjust their portfolio construction. This could involve holding larger pools of cash, more conservative asset selection, or ‘bar-belled’ portfolios that have a higher level of lower-return liquid assets and a smaller level of higher yielding but more illiquid assets to maintain returns. This could also have an impact on which borrowers are able to access capital markets easily, most likely to the detriment of corporate borrowers and to the benefit of high grade borrowers.
Regulation is taking its toll on market liquidity via dealer banks
Since the global financial crisis (GFC), regulation has been slowly changing the fixed income marketplace globally. The traditional intermediaries in fixed income transactions, dealer banks, have been reducing both their role in these deals and their bond inventories. Without banks standing behind the market and offering their balance sheets as a stop-gap measure, the ability to allocate swiftly and regularly between asset classes and securities is significantly reduced.
Banks are likely to still remain active participants in high grade markets where they need liquid assets for their own needs (such as government bonds, semi-government bonds, supranationals and other bank paper). However, their commitment to the corporate bond market will probably weaken over time, other than as an arranger of deals. There will potentially be greater focus on banks directly lending to corporate clients and, as such, competing with the corporate bond market. This may make investors more wary of bank bonds as there is the potential for greater issuance with a different business mix (at least domestically) and perhaps these bonds should trade at a wider spread. It is another reason why investors need to be increasingly focused on being active in the market to avoid losing diversity of issues.
This increase in regulation will lead to increased costs. The requirement for asset managers to improve risk management systems and trading platforms to meet regulatory and market changes will also increase costs, some of which is likely to result in increased costs for the end clients. This, coupled with potentially lower returns, may affect the types of products offered by asset managers (since some may become unprofitable) or may lead to asset managers offering certain strategies only to a select group of investors who are willing to pay for consistent alpha generation.
Changes to trading execution may assist in increasing liquidity
If market trading facilitation were to move to a full broker-style market, similar to the operation of the interbank market for certain asset classes, then banks could become participants alongside buy-side, hedge funds and any other participants, rather than acting as market makers. As a result, the bid and offer would be determined by a larger group; investors in this scenario could no longer be passive price-takers and would have to help provide liquidity.
This scenario would be difficult to manage under current client mandate structures and is not how most asset managers currently operate. However, there can be value in being able to trade into markets more regularly, even at a smaller transaction size, and to turn over stock. This might mean that bid/offer spreads need to be wider to encourage and compensate those providing liquidity. For derivative markets this would hasten the move to clearing and/or moving derivatives from over-the-counter (OTC) to futures contracts.
In addition, the concept of best execution in markets assumes multiple bids/offers and very low transaction costs. In our view, this may have to change since the ability to access a large array of price makers is no longer going to be possible and the available liquidity on any particular day may not always be the best execution point.
Electronic systems may make trading easier, but they are unlikely to add liquidity to a market unless the point above is addressed by all parties in the market (i.e. the willingness to assist in providing liquidity rather than just being a passive participant). Liquidity needs to be achievable regardless of the dealing mechanism and the infrastructure of the market requires sufficient compensation to facilitate liquidity in all stages of the cycle. Electronic trading platforms have the potential to help this, but in themselves cannot create liquidity without a change in market behaviour.
Conclusion: Attitudes toward liquidity may need to change as market changes
Liquidity in financial markets is a function of matching participants’ requirements. In good times, it may be possible to run a mismatch without cost, but in times of stress either investors have to deal with sharp drops in asset prices or issuers lose access to markets. If there is no natural last resort liquidity provider, then market participants should be willing and able to step into the market to facilitate this. This would require a change of thinking, both in terms of willingness to participate, but also for investors to assess the level of liquidity risk that they are prepared to bear when investing in any fixed income security or managed fund. Changes in asset allocation are not without cost and to earn a return that is greater than the risk-free rate often means accepting a longer investment horizon and with this the potential for reduced liquidity or longer asset disposal timeframes.