Sector and Credit Strategist - Global Liquid Strategies
Director, Research & Strategy – Global Liquid Strategies
A great deal of investment industry commentary these days reads like a tale of woe. High on the list of complaints is overbearing regulation that has drastically reduced liquidity and made it harder and costlier to trade.
There is no force majeure clause to get investment professionals off the hook. Institutional clients and those they serve – members of superannuation funds, retirement plans and savers – continue to require good returns and we believe pockets of opportunity do exist.
Corporate credits are a prime example, in our view. The greater liquidity risk is being compensated by a higher premium assigned to corporate bond yields.
For investors that don’t require instant liquidity or are unencumbered by mark-to-market pressure, the current higher premium demanded for “illiquidity risk” presents an opportunity to experience a form of financial schadenfreude – to gain satisfaction from others’ misfortune.
There is an important caveat to keep in mind. Credit-investing, even in quality names, is a far cry from set-and-forget investing. A blasé attitude is the antithesis of successful credit investing. Watchful eyes – active monitoring – must be ever present.
Rahm Emanuel, Barak Obama’s sharp-tongued former chief of staff’s words were often unprintable. His remarks soon after President Obama took office amid economic peril were an exception; “You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think you could not do before,” are both publishable and meaningful.
To be clear, we are not suggesting that today’s investment and economic situation is crisis-like. The true crisis – when the world was staring into the abyss – was the 2008/09 period.
That wrenching time transitioned into “The new normal,” describing an era of below-average economic growth. Nouriel Roubini followed by tweaking it to “The new abnormal” an unsettling mix of below-par output and inflation, with asset prices that have raced ahead of fitful economic growth, give or take the odd sell-off and scare.
Rather than crisis-like, the contemporary investment climate is one in which lulls are interrupted by random outbursts of volatility, perplexing investors familiar with the more predictable cycles pre-GFC.
However, instead of falling into an ultra-cautious mind-set, we think those investors who can look through the volatility and for whom the ability to rapidly sell their holdings is not a priority can benefit from the higher cost for liquidity currently (Figure 1) being paid by those who do need it.
Liquidity, like any pivotal investor factor has a price. The first line of defence against liquidity concerns is intensive analysis; the second is adaptable execution strategies.
Too often illiquidity is thrown up as an excuse for poor risk management. For instance, there may be no liquidity for a bond at 95 cents but ample liquidity at 70 cents.
A change of execution strategies is another road worth exploring. An investor may hold $20 million of a particular bond while the market maker’s price is for only $5 million of the parcel. However, they are also willing to buy the full $20 million at a lower price. The investor has choices to make: sell it all at a discount or patiently work out of the position.
Both exit strategies reduce portfolio returns and investors are demanding higher yields to bear this risk.
Our analysis of the three components of credit spreads – default compensation, market risk appetite and liquidity cost – suggests that there has been a persistent increase in the liquidity component while the other factors continue to behave as normal.
Regulatory reforms beget diminished liquidity
Before the 2008 crisis, banks were highly active traders and also provided a “warehousing facility” for fixed-income instruments. They held substantial trading inventories and thus were able to take large blocks onto their balance sheets helping to smooth price volatility.
Regulators concluded that such activities were among the risks that sparked the GFC and so introduced a raft of regulations to make the banking system safer.
Initiatives such as Dodd-Frank and the Volker Rule in the US, and Basel III globally have caused a number of participants to withdraw completely while others have significantly scaled back their market making functions. So in times of surprise, the banks are not as capable of acting as stabilisers.
The upshot is that upsurges of illiquidity-related risks are becoming more unpredictable making life tougher for all investors but particularly those with a short term focus.
Active traders continue to act on their ideas but at times have to accept compromises such as reduced position sizes or accept higher hurdles to do so. Meantime, forced sellers can still raise cash quickly albeit by accepting lower prices in exchange for speed of execution especially if they are trying to unload large positions.
Daily price changes in the US Treasury bond market provide one insight into the impact of reduced liquidity. Volatility has stepped up visibly in recent years. It seems that six standard deviations have become the new two (Figure 2).
Market spikes and ‘air pockets’ in prices are no longer uncommon events. They have become more frequent and severe.
Where once unusual market dislocations would lure a host of traders eager to profit from the temporary distortions, a deluge of post-financial crisis changes is now dissuading them from doing so.
With balance sheets at the big dealer-banks under pressure, active traders are unable or reluctant to put on large trades, so odd dislocations in the markets can now persist indefinitely while other violent swings in valuation can be too short-lived to monetise.
The authorities not convinced, markets say otherwise
To be sure, there is some disagreement between policy makers and regulators on one side of the divide, and markets on the other, on the magnitude of liquidity challenges.
The US Federal Reserve, for one, points out that bid-ask spreads are back at pre-crisis levels to support their contention that new regulations are not impacting liquidity.
Meanwhile a study by the TABB Group suggests otherwise. They estimate that between 2007 and 2015, the aggregate corporate bond balance sheet capacity among the top 10 primary dealers within the US dropped 21 per cent– a reduction to US$95 billion from US$120 billion.
By extension, as the size of the market grows, the impact of this figure's decreasing total will greatly affect the secondary market-making ability of major dealers, which already is a challenged segment of the US corporate bond market.
The total value of US investment grade bonds outstanding (JP Morgan JULI Index) leapt from US$1.4 trillion to US$5 trillion. So, aggregate balance sheet capacity has dropped from 8.6 per cent of the market to just 1.9 per cent, a very significant structural shift.
While dealers are still the predominant intermediator for over-the-counter bond trades, the manner in which they now provide this function has become more like that of a real estate agent matching buyers and sellers. It’s less direct and precise. More haphazard.
Liquidity premium opportunity for patient investors
Instead of being consumed by illiquidity issues at this juncture, many investors are focusing on true credit risk – default risk, which in the long run differentiates actual returns from expected returns. However, we believe the liquidity premium factor is sure to play an increasingly important role.
We estimate that since 2012, the Australian investment grade liquidity premium has settled-in about 50 basis points higher than pre-crisis (Figure 3) . The US investment liquidity premium has been climbing since the end of the Fed’s quantitative easing program (QE). Patient investors can harvest this premium.
By contrast, the European liquidity premium, which had been rising, has trended down since the ECB started its own QE program.
Bond cashflows enjoy strong legal protection
Investment professionals are zealous about their specialisations. Equity market proponents speak up for their asset class. Fixed income investors for theirs. Alternatives investors for theirs and on it goes.
It’s not a zero sum game. Portfolios benefit from diversification.
In times of a generalised flight from risk, even credits that can reasonably described as “quality” can be sold-off as indiscriminately as their higher-yielding/higher-risk counterparts. Indeed, they are often the only assets than can be sold in stressful times.
Having said that, we are credit enthusiasts, especially in the context of today when higher potential returns are on offer thanks to the greater liquidity premium.
Moreover, cash flows from corporate debt securities are enshrined in contract law, unlike dividends paid to equity holders. So, regardless of the ebb and flow of market pricing they can be relied on to pay interest on the due date and to fully repay capital at maturity – unless the borrower goes out of business.
As well, in a worst case scenario, that is; in the event of a company collapse, creditors stand first in line to recoup any residual remaining value in underlying assets. Put differently, creditors have higher claims on a company’s cash flows than shareholders.
Investors with the intestinal fortitude to stand by quality assets can be rewarded for research-based conviction.
Our own experience attests to this.
During the GFC, the value of our holdings owned on behalf of clients in BAA (now known as Heathrow Airport Holdings) traded as low as 30 cents in the dollar as banks in liquidation were forced to sell at any price.
Our extensive due diligence on the airport convinced us that its sound credit-metrics, dominant market position, regulated cash flows, and strategic value would enable the company to keep paying interest and to repay its debts as they fell due even in a subdued post-GFC climate.
As events transpired, that’s just what happened. Creditors received uninterrupted coupon payments and were also repaid 100 per cent their initial capital outlay at maturity. None of this happened by chance.
We researched BAA intensively before making our buy-decision and monitored fiercely during the worst days of the GFC as well as through the investment’s lifespan.
Credit-investing, even in quality names, is a far cry from set-and-forget investing. Diversification across companies, industries and countries are timeless investment principles.
A blasé attitude is the antithesis of credit investing. Watchful eyes – active monitoring – must be ever present.
No compulsion is involved, but choices do have to be made and investors must adapt.
For those investors unencumbered by mark-to-mark demands and able to manage their liquidity needs, a diversified portfolio of investment grade credits offers a rare opportunity to experience financial schadenfreude.
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