Liquidity remains a concern in fixed income markets, but investors should not only think of this issue within the context of it being a large-scale problem.
A more likely outcome of poor liquidity is a slow and steady erosion of returns over time as fund managers struggle to implement objectives, see their weaker ideas magnified, and are forced to hold assets they do not want to own.
It is not news that there are liquidity problems in fixed income markets – the issue has been highlighted by many asset management groups and august institutions, such as the Bank of England.
However, these concerns have been framed within the context of a liquidity crisis – a squeeze on fixed income markets that may mean investors cannot get in and out of bonds – while the real risks may in fact lie elsewhere.
Investment managers are increasingly taking measures to manage the liquidity in their funds. Some have been investing higher weights in cash, others in exchange-traded funds, while some are looking to derivatives and other blended options. This helps address the mismatch between the liquidity offered to investors – usually daily dealing – and the liquidity offered by the markets. This is a sensible response, clearly better than simply suggesting the problem will go away, but the concern for investors is the price they are paying for that liquidity.
There is a danger that the pressure of managing liquidity erodes returns for investors.
This may happen in a number of ways: poor liquidity tends to exaggerate portfolio movements. For example, during the most volatile periods in the market in recent months, there have been some bonds that have proved impossible to trade: energy bonds, for example, or other parts of the high-yield market.
Those who have seen redemptions and are also exposed to these sectors, have been forced to sell their most liquid holdings, which consequently increased their weightings in the less liquid parts of the market that they could not sell.
This may not matter – energy or high yield may prove to be the perfect place to be invested – but if commodity markets lurch lower, this illiquidity will exaggerate the movement. There is also the wider issue that fund managers are, to some extent, being forced to compromise their investment styles by the constraints of liquidity.
The same is true for high weightings in cash or derivatives. However, floating-rate notes, which are highly liquid, can be a valuable tool in insulating portfolios when interest rates do eventually rise.
Rates will at some point go up in this environment and investors will want to be at the short end of the bond market when they do. The risk is that investments are held for liquidity alone and funds experience ‘mission creep’ – a gradual shift in objectives.
This can also happen with derivatives. It may often be easier to implement portfolio ideas through derivatives. They are more liquid and, with wide bid-offer spreads on conventional bonds, may be cheaper to trade. They have their place, but the question is whether they are an exact proxy for the underlying instrument and whether investors in a conventional fixed income fund are happy for it to be loaded with derivatives.