Fri, 31 Jul 2015
Morningstar's Sumit Desai explores which parts of bond market are most susceptible to a liquidity event, what fund managers are doing in response, and how investors can protect themselves.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Bond-market liquidity was a hot topic at the recent Morningstar Investment Conference. Joining me to discuss that issue is Sumit Desai--he is a senior analyst at Morningstar.
Sumit, thank you so much for being here.
Sumit Desai: Thank you for having me, Christine.
Benz: Before we get into bond-market liquidity specifically, let's talk about liquidity in general and why it matters to investors.
Desai: To your point, I think liquidity can mean different things to different people. We joke around a lot amongst my colleagues that liquidity is a very fluid concept, but I think that actually is a true assessment of the market right now. Howard Marks of Oaktree wrote about the topic recently, and he had a very relevant definition of liquidity: It's not just the ability to sell an asset or security, but really the ability to sell a position at a price equal or close to its most recently quoted price. So, can you sell a position without impacting the price that the market is quoting you at?
Benz: At the conference, there was a lot of handwringing about potential liquidity problems in the bond market. Let's talk about what bond-fund managers think could be potential catalysts for some sort of an illiquidity problem for bond investors.
Desai: I think liquidity is interesting because it can come and go. You can have a very liquid market one day, and if sentiment changes the next day, it can go away. In terms of a catalyst--what can really cause an illiquidity event--obviously the hot topic of the bond market today is rising rates. We're coming off of this zero-interest-rate policy that we've had for a long time, so what's going to happen when the Fed raises rates and how are bond investors going to react? I think, in an environment where you see rising rates, that maybe could cause investors to run for the exits in a worst-case scenario. We've seen a lot of money going into this space over the past few years; the taxable-bond category has grown from just under $1 trillion to almost $3 trillion in a matter of less than 10 years--all pretty much in one direction. So, we've had a lot of money going into that space. In an experience where rates rise and investors flock out, that would be concerning.
Interestingly enough, we've seen situations like that. At the end of 2013 and the beginning of 2014, there was a situation where we actually did see the beginning of a lot of investors leaving fixed income in what was known as the "taper tantrum." That was a situation where a couple of months later, you saw a little bit of volatility; but within a couple of months, investors were able to go back into the market. They saw that valuations were a little bit more attractive, and they provided a little bit of a backstop, so that was an interesting impact.
Another interesting area that I think could potentially serve as a catalyst is any kind of credit event. We saw this in high yield in December 2014 when oil prices were plunging. Energy makes up a large part of the high-yield market, so I think that oil-price decline spooked a lot of investors, and they ran for the exits again. [As a result,] high yield experienced a little bit of a liquidity issue at that time as well. And I think this is the same within munis, for example, too. A credit event around Puerto Rico or Greece is really going to worry investors. That flight to quality may cause potential concerns around liquidity.
Benz: So, bond investors are kind of walking this tightrope with interest-rate sensitivity on the one side and credit risk on the other side. But let's talk about why a lot of sellers from a given bond type would, in fact, potentially cause liquidity problems?
Desai: One of the outcomes following the financial crisis was new bank regulations that effectively required banks to maintain more conservative balance sheets. What that meant in some situations is that banks--specifically broker/dealers--were less willing to hold inventory and serve as a natural trading partner for a lot of the fixed-income funds out there. So, we've seen data that would imply that dealer inventories are down anywhere from 70% to 80%. So, there's really just less money available on the broker/dealer side to trade with partners. Even in a perfectly functioning market, if there are more sellers than buyers, the price of an asset is going to decline. But I think, given this dealer-inventory type of environment, risk is really magnified right now.
Benz: Let's take a look at some of the bond types that could be the most vulnerable in some sort of a liquidity event. I know we generally think of Treasury bonds as maybe being the most liquid bonds in the market. But what are the bonds that could really suffer in some sort of a liquidity event?
Desai: There are a couple of different areas. I think the credit markets are one area where we see a lot of headlines around liquidity. I think some of those are fairly valid concerns. We've some really strange behavior in the bank-loan space, for example. Bank loans are an area where, if you own a bank-loan position, one challenge is finding a buyer if you want to sell it. That's a challenge in itself. On top of that, within the bank-loan space specifically, for a variety of reasons, the settlement times are very long. It can often take anywhere from four days to I've heard as much as 60 days to get your money once you sell a bank loan. That's very concerning in a fund that's promising daily liquidity. And sure enough, we saw this issue really come to a head in December of last year around the same time as the energy sell-off, when there were a handful of bank-loan funds that experienced very large redemptions and were almost required, in some cases, to tap into lines of credit to meet those redemptions. That's an area where it's concerning. I think, in general, the further down in quality you go, it's safe to assume that you're going to be giving up some liquidity. So, that's something to aware of, too. Say you're in a fund that tends to own lower-quality bonds, liquidity might be a concern there, too.
Benz: And that would hold true for municipal-bond funds as well, I would think.
Desai: Absolutely. I think the concerns around dealer inventory are spread across all sectors of the fixed-income market--munis are included in that.
Benz: One area that has enjoyed increasing uptake over the past few years has been the ETF space. Investors have been buying high-yield ETFs as well as some bank-loan ETFs. How might they be impacted in some sort of a liquidity event?
Desai: The ETF space is an interesting challenge in itself within fixed income. I think that a lot of investors will assume that ETFs do provide a little bit more liquidity--and I think in many cases that is, in fact, the case.
Benz: You trade intraday, which you can't do with a conventional mutual fund.
Desai: Exactly. You can't do that with a mutual fund. So, I think, especially for investors who may be interested in some shorter-term trading around an asset class, ETFs are a great vehicle. The concern around ETFs is that if you go under the assumption that the underlying bonds--high yield, for example--are illiquid, I think it might be unwise to assume that the overarching ETF is going to, all of a sudden, provide you liquidity.
So, there's always going to be a little bit of liquidity risk within the ETF, if the underlying investments are illiquid. You saw that in 2008 and 2009, for example, when there were dislocations within high-yield ETFs between the value of the ETF and the underlying NAV. Sometimes, the ETF will trade at discount to its NAV at potentially the worst possible time. So, that's something you need to look out for within the ETF space.
Benz: One thing you mentioned was that a fund manager mentioned to you that bond investors aren't necessarily demanding a sufficient premium for this liquidity risk that they're accepting. They're getting maybe a premium for the credit risk, but not so much for the risk that there could be some sort of liquidity shock.
Desai: Yes. If you look at it from a valuation perspective--and we'll use high yield as an example--spreads within high yield are right around average, if not maybe a little inside average on a historical basis. But what doesn't necessarily get accounted for is the fact that there's a lot more liquidity risk, and you're not necessarily getting paid for that. So, while we're right around average, we're not really in an average environment right now. Maybe that needs to get adjusted a little bit in terms of valuation.
Benz: When you look at what fixed-income managers are doing--if this is a big concern for a lot of managers--how are they changing the positioning of their portfolios to perhaps account for this possibility that there could be some liquidity shock?
Desai: There are a few different things that we're seeing managers do. The obvious hedge against liquidity risk is holding more cash; that's going to dampen the volatility around liquidity and also allow the manager to hopefully take advantage of dislocations when they do occur. Having more-liquid holdings within the portfolio--more Treasuries, more higher-quality mortgage-backed securities that are somehow backed by the government--these are fairly liquid investments. They're shorter term, in general; the closer you get to the shorter end of the yield curve, presumably the more liquid [the issues are] because there is just less uncertainty around there.
We've seen some interesting things operationally from the fund companies that we follow, too, that I think address a lot of the issues around liquidity. One of them, we already mentioned this, is lines of credit. Bank-loan funds have used their lines of credit recently to meet redemptions, but almost every fixed-income firm that we speak to has some line of credit in place as sort of a backstop in case of heavy redemptions.
Another area where we've seen fund companies address liquidity is via interfund lending. I think PIMCO was written up about this in the media recently when they were experiencing heavy redemptions. One of the ways that they were able to meet some of those redemptions was via interfund lending--maybe temporarily borrowing from one fund to another or selling from one fund to another. There are some legal technicalities around that, so the fund companies need to be very careful. There can be some unintended risk. But it's something we are seeing as a backstop.
Another thing that I think fund companies can do--some do this and some don't--is have a third-party risk-management group within the firm look at this issue independently from the fund manager. I think, as a fund manager, there might be a natural bias or tendency toward painting a rosy picture. It's no fault of their own; it's kind of understandable that you don't want to cause panic, and everyone has a different perspective. That's why I think an independent third-party assessment of liquidity within a portfolio would really add value.
Benz: So, now that we've scared everyone to death concerned about liquidity, let's talk about what individual investors should do--how they can size up their portfolios and potentially get their arms around some of these risks that could lurk in their portfolios.
Desai: This conversation isn't meant to scare investors, by any means. It's really just meant to create awareness around the topic. It's not something that needs to be an immediate concern or something that should cause any kind of panic. Investors should just set their expectations accordingly. I think it's important to think long term. A lot of these liquidity issues can cause short-term dislocations in the market; but if you are investing over a long time horizon and you really aren't too worried about short-term dislocations or market movements, you should be OK--all else equal.
So, I think it's important not to trade in and out of these names, especially on the ETF side, as we mentioned--but on the open-end side, too. Consider holding some cash, also. As an individual investor, you are not beholden to the same type of performance and results that a fund manager will be, so there is nothing wrong with holding a little bit of cash to take advantage of a market sell-off when there is one.
Another interesting area that we've seen that could potentially address some of the concerns around liquidity is closed-end funds, specifically in some of the less-liquid areas of the fixed-income markets--for example, bank loans and high yields. Closed-end funds don't have to deal with redemptions, and the concept of redemptions is where a lot of the concerns around liquidity come from. So, if you don't have to worry about redemptions, closed-end funds can be an attractive option. One of the benefits right now is that some of them are trading at decent discounts to their NAVs, so they might provide attractive opportunities as well.
Benz: Sumit, this is a big important topic. Thank you for being here to share your insights.
Desai: Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.