Questions are increasingly being raised about whether bonds are liquid and what risks exist if they aren’t. In recent years Blackrock has written frequently on this topic. Their latest piece notes that despite the growth in the total value of bonds outstanding globally, the market is becoming increasingly fragmented1. They point out that some US banks have more than 1,000 bonds outstanding, with some large corporates having dozens of bonds outstanding. Other recent articles point to the decreasing size of trades occurring and that with new regulations banks are increasingly becoming trade arrangers rather than middlemen using their balance sheets. The problems are known, but the solutions are still being discussed and there’s seemingly little momentum to change the status quo.
Proposals to Improve Bond Liquidity
Blackrock proposes that issuers should move to fewer, larger bonds (perhaps a maximum of one maturity per year) with standardised terms. This would dramatically reduce the total number of bonds outstanding as well as reducing the seemingly subtle differences in key terms that govern each bond. The recent push to include collective action clauses in all sovereign bonds is a live example of an attempt to standardise terms.
Another suggestion to improve liquidity is for trading to migrate to exchanges rather than through brokers, with a centralised order system making it far easier for buyers and sellers to find their match. Listed notes in Australia have achieved very good levels of trading helped by transparent price information and orders. If the company and yield offered are attractive, issues of more than $1 billion are eminently possible with the latest Commonwealth Bank issue gathering $3 billion. However, listed notes come with increased volatility in prices relative to unlisted bonds. The predominantly non-institutional investors arguably focus less on fundamentals and more on sentiment.
Why Liquidity Matters
An example of why all of this is important is highlighted by recent news on Pimco, with the departure of Bill Gross triggering a wave of redemptions from both its Total Return Funds. The ETF version of the Total Return Fund is being investigated by the US securities regulator (SEC) over its pricing mechanics2. The SEC investigation is dealing with one of the long-standing issues with bonds, how do you value holdings of unlisted securities of varying sizes and with different terms, when some have traded recently and others haven’t? The initial claims are that the Pimco ETF bought small parcels of bonds, which trade at a discount to larger parcels due to their lower liquidity, and then marked up those small parcels to the levels that larger parcels had most recently traded at.
In normal times there wouldn’t be any concerns about the liquidity of the ETF. However, concerns have been raised with redemptions of approximately 15% of the fund in two days following the departure of Bill Gross. Could the ETF become illiquid if the redemptions continue at a high rate? Could the previously profitable strategy of buying smaller discounted bonds come back to bite Pimco?
Illiquidity issues can become a self-fulfilling prophecy as the more liquid positions are sold to fund redemptions leaving a rump of illiquid positions. ETFs and managed funds with daily or weekly liquidity are particularly susceptible to being caught out. These vehicles should only be holding the most liquid securities, matching the very high level of liquidity they offer their clients. Australians with a decent memory will remember the billions locked up in mortgage funds when the financial crisis hit – a classic case of liquidity mismatch. Long dated illiquid mortgages, although in many cases very low risk ones, weren’t able to be sold to meet the redemption requests flooding in.
Managing Liquidity Risk as well as Credit Risk
Increasingly, bond investors need to consider not just the credit risk but also the liquidity risk of their holdings. Very small or very large holdings of individual issues, as well as esoteric securities are particularly prone to being difficult to trade. Liquidity is also cyclical, as summed up in the common fund manager euphemism that “liquidity is always available except when you need it”. This was seen for both listed and unlisted securities during the financial crisis with the buy/sell spread widening from basis points to percentage points in some cases. Buying smaller ticket securities at a discount is a legitimate strategy to generate alpha but it is suitable only for investors who have a ‘buy to hold’ outlook. Some investors want to receive a liquidity premium on the securities they invest in but they don’t want any limitations on the liquidity of their investment. You can’t have the best of both worlds – it will end badly.
Why Investors want Liquidity
The underlying issue of why investors want liquidity is also important. I’ve found the two main reasons that people want liquidity are:
(1) they want the ability to sell if their situation changes, or
(2) they want the ability to sell if the investment outlook changes.
Each is understandable, but they impact the way investments should be made and limit the risk that should be taken. If liquidity is needed for personal situational changes then short tenor securities or very low risk securities are the best match. There has to be a compromise and that will be a reduction in the credit spread earned.
Liquidity for investment outlook changes is a very different story. I’m a strong believer in the Warren Buffett maxim that investors should only buy securities that they are happy to own if the market closes for 10 years. If the long term return for risk isn’t acceptable now then that is a situation ripe for a future correction. Many investors believe they can foresee the signs of a market peak, yet very few have acted correctly and consistently at market peaks. For the vast majority of investors, by the time they’ve recognised the signs of a downturn the prices have shifted down well beyond their desired selling level.
The Definitive Form of Liquidity
When there is a comparison between investment opportunities in different asset classes there are two additional points that are critical. Firstly, debt securities have the added benefit of either a hard maturity date or an amortisation pathway. Secondly, debt securities have a slice of equity below them that takes the first losses. If you get the initial investment call a little (but not a lot) wrong, the security price will likely be marked down but then gradually work its way back to face value as it approaches maturity. You’re not stuck forever hoping for a business or market turnaround, there’s an approaching date when things will come good. A maturity date is effectively a second form of liquidity, but with a far more reliable timeframe and price. In a time of crisis, an approaching maturity is doubly valuable as it allows for the cash received to be re-invested into other securities at cyclically low levels.