Since I last wrote about liquidity for debt securities in September 2014 the topic has become something of a staple for journalists looking to create a “here’s something to fear” article. The standard story will have a graph of the total amount of debt available and the total amount of dealer inventory held1. Whilst total debt levels have increased rapidly, total dealer inventory has shrunk substantially. The article then concludes that in the next crisis there won’t be as much dealer liquidity available which could create chaos in debt markets. I find this a naïve and simplistic view so this month I’m going to discuss how I believe debt markets really work in a crisis and pull apart some of the fallacies I’ve been reading and hearing about liquidity. In doing so, I hope this helps you understand better about how liquidity might work when the next crisis strikes. (Feel free to take your own view how far away the next crisis is.)
For credit investing, it is true that history doesn’t repeat but it certainly does rhyme. As the market moves through panic, stabilisation, growth and euphoria stages investors lose their inhibitions and take on increasing risks for decreasing returns. At some unknowable point, the earth shakes and the unstable structures come falling down. A financial crisis is the market’s way of cleansing the system of dumb lending. Feel free to read the credit cycle article I wrote in February 2014 if you want to think through how to invest in each stage of the cycle2.
Dealers aren’t a Charity
Arguably the most common misconception about liquidity is that because dealers now have smaller amounts of balance sheet available to facilitate trades there will be less liquidity around next crisis. The reality is that dealers aren’t going to attempt to catch a falling knife unless they are near certain they will make a large profit from doing so. In a time of crisis dealers stop bidding for assets as their clients stop showing interest in buying from them. This was true last crisis and it won’t change in the future. There will be securities that dealers simply will not offer any price for immediately, but if given a few hours they will still try to find another side for the offer and look to earn a margin for the service. Liquidity has a price, dealers have never been a charity giving away liquidity for free nor will they ever be.
Liquidity is very different for Debt and Equities
There’s two key differences between debt and equities that impact their liquidity. Firstly, equities are typically standard issue securities where every investor is buying the same rights and terms. Debt securities are more like a buffet, with all sorts of options for investors to choose from the one issuer. Finding buyers is therefore much more complex for debt as you need to find someone who will offer a price for the specific security you are looking to sell. A potential buyer might like the issuer of the debt, but not the structure or maturity date of your particular debt security.
The second key issue comes from the level of disclosure of bids, offers and trades. It used to be simple with debt trading “over the counter” through dealers and equities trading on exchanges. This is changing, with more debt trades occurring through exchanges and more equity trades occurring through alternative venues such as dark pools. Many debt securities don’t trade frequently, and when they do trade it is not always clear whether the price is an accurate reflection of a willing buyer, willing seller market. Putting a price on a debt security is far more complex than just using the last known traded price.
When a crisis strikes equities can be quite volatile but there’s at least good disclosure of where trades have occurred and where potential buyers and sellers are prepared to trade. For debt securities, you may struggle to find someone to offer a bid if the size is too small or too big. Information about where debt securities might trade is scarce and dealers aren’t motivated to be helpful in sharing information as they can make a greater profit on trades if buyers and seller don’t know who is willing to trade and at what level they would trade. If a debt security hasn’t traded for months how can you argue that a 10% price drop from the last trade is unreasonable? Is the dealer trying to take a greater margin or is it that there’s only one buyer today for what you want to sell?
Perception of Risk is More Important than Reality (in the Short Term)
When a crisis hits and you want to sell it all comes down to perception. If the securities you hold are perceived as low risk, like government bonds used to be, then people will want to own more of those and you’ll find it reasonably easy to find buyers. If you are holding something that is complex and perceived to be risky, like CDOs, you may struggle to find a buyer at anywhere near where it was last marked. Things like a better credit rating and shorter duration help the perception of risk, but some sectors are far more likely to be perceived as risky and therefore will suffer more.
Some examples of sectors most exposed to perception changes if there is a global recession are mining and mining services, property developers and construction, airlines, shipping and discretionary retailers. In terms of security types I’d put forward weaker sovereigns, US state and local government debt, emerging market debt and US auto and student loan securitisations as more susceptible. Recent vintage non-prime US and Australian residential securitisations are also likely to be sold off initially, but the prospects for recovery are strong as lenders have generally learnt to check a borrower’s income levels and ensure there is a good down payment.
Vehicles and Securities have very Different Liquidity Risks
When you buy an individual bond or loan, the key risks are mostly about yourself. Did you make a good judgement about the credit quality of the issuer and the security? Did you choose debt instruments that match your liquidity needs? Are you likely to sell out simply because the market is falling rather than making a decision to sell based on the underlying performance of the issuer? When you own good quality bonds, you will find that liquidity varies over time but you can rely on each day bringing you closer to the ultimate liquidity event – the security maturing.
When you invest in a fund you take on a whole new range of risks. You now need to ask additional questions such as will the co-investors exit at an inappropriate time? Will you be left more exposed to lower quality or less liquid securities as some co-investors depart and assets are sold to fund redemptions? Will the bid/offer spread be sufficient to cover the costs incurred by co-investors leaving the fund? Will the manager use gate mechanisms to protect their interests or your interests? If there is leverage in the vehicle, will there be a capital call in order to stop fund assets being liquidated prematurely?
Open ended pooled funds are a much more difficult risk to analyse as you are forced to make decisions not only about what liquidity might be available for the investments held but also what actions others might take. If the fund has illiquid investments but regular liquidity options investors are at risk. Again perception is key, if the fund is seen as low risk then investors are more likely to stay and liquidity issues can remain suppressed. However, if a fund is perceived as risky its demise is almost guaranteed. Once redemptions begin en masse, remaining investors perceive they are at a high risk of being left stranded and the safest option is to redeem immediately.
Open ended funds built on liquid instruments that consistently trade in high volumes and without gearing are the best positioned to survive a liquidity run. Large capitalisation equities, money market securities and the top tier of short and medium term investment grade rated securities are a stable foundation. Small and micro capitalisation equities, unlisted property and unlisted infrastructure are all illiquid assets in the best of times. High yield bonds and leveraged loans have decent liquidity now but that will change when the next crisis strikes. Using these securities in pooled vehicles with regular redemption options is like building a house on a foundation of sand.
The standard line that dealer liquidity has reduced therefore the amount of liquidity available will be reduced in the next crisis is a simplistic and naïve view. Liquidity comes at a price and that price will vary over time. Investors should construct portfolios keeping in mind that liquidity won’t always be available for all types of debt securities.