You do not need to look hard to find market commentary highlighting fear and worry over liquidity in corporate bond markets. We can understand why. The low interest rate environment has driven new participants into corporate debt and led to record levels of new bond issuance. Some of the new participants are yield1-starved investors seeking income. Others are traders that focus on tactical models, momentum and leveraged strategies. It is reasonable to assume that most of these new participants are likely short-term investors. Many will turn seller when central banks raise rates. It is this exodus of temporary high yield investors which is the focus of the worry over the state of the credit markets. We don’t necessarily dispute these concerns, but it does seem that liquidity risk has evolved into a culprit of convenience, an attractive red herring to comfort analysts, regulators and media that “The Risk in the Market” has been identified. We caution investors not to be as easily distracted.
When we talk about liquidity risk, we are talking about the loss or haircut that a bond holder will realize when forced to sell. This loss is exacerbated in steep sell-offs, and the resulting volatility is often mischaracterized as illiquidity. In an effort to mitigate this risk, it is a common strategy in credit markets to transact in larger, well known bond issues that trade frequently because they are more liquid. Many investors equate liquidity with large, frequently traded bonds. By this measure, Sprint Corp’s $2.25 billion 7.25% notes would be more liquid than, say, Lions Gate’s $225 million 5.25% notes. Readers can probably guess which one of these two bonds is held by the large high yield exchange traded funds (ETFs)2.
We believe issue size and frequency of trades will turn out to be poor indicators of liquidity if the market goes through a dislocation. These are backward looking metrics and not likely indicative of what happens when the temporary high yield investors head for the exits, selling out of passive vehicles like ETFs as they go. Contrary to what pundits say, we believe that these large “liquid” bond issues could be where much of the loss realization will be concentrated. In short, these bonds may not hold their value when the market needs it the most.
Furthermore, just because a bond does not frequently trade does not mean there is a lack of demand. We can point to several bonds where we and other existing holders are keen to own more, and our frustration in recent volatile markets has come not from too much supply but from the fact that no sellers can be found. This is a counterintuitive concept to those not immersed in analyzing and trading such bonds daily. A recent example of this type of supply/demand imbalance can be found in a new bond issue from Scotts Miracle-Gro, maker of fertilizer and poisons. The company, which has a strong credit profile, marketed a new $300 million bond for which there were $2.3 billion of orders to buy. Not all of that demand is likely to be there in a sell-off, but there should be more support than in the case of a company that lets its bankers sell as much debt as the market can digest, regardless of the resulting leverage (see Sprint vs. Lions Gate above).
Further stoking liquidity fears is news that dealers are stepping back from using their balance sheets to hold corporate bonds. Based on statistics from the Federal Reserve Bank of New York, primary dealers’ inventory of corporate bonds peaked at $235 billion in October 2007 and decreased to only $13 billion in September 2015. There was a sharp decline in inventories during the financial crisis as dealers joined in on the sell-off, and because of new bank regulations, these inventories continued to fade rather than snap back.
There is a constant stream of commentary from media and prominent fund managers practically shouting about liquidity risks stemming from lack of dealer involvement. We think this commentary is missing the point. From our experience in prior credit default cycles, dealers were hardly ever there to use their balance sheet to support liquidity in a sell- off. They actually made it worse as they sold alongside funds. Low dealer inventories may actually be healthy for the market. Starting from a low point in their inventories, dealers may not be competing with funds to liquidate positions in a meltdown. Maybe, with less cluttered balance sheets, some capacity even exists for dealers to provide a liquidity bid when some need it most. Perhaps we need to consider who is doing the shouting – large funds with large positions in less desirable credits (like energy bonds) that are struggling to find bids as they face investor redemptions.
By Venk Reddy
Originally published in Q3 2015 letter
1 Yield is the return an investor will realize on a bond purchased at the market price and held until its expected redemption date.
2 An exchange-traded fund is a type of investment company traded on an exchange whose investment objective is to achieve the same return as a particular market index. ETF’s are subject to specific risks, depending on the nature of the underlying strategy of the fund. These risks could in- clude liquidity risk, sector risk, as well as risks associated with fixed income securities, real estate investments, and commodities, to name a few.
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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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