Suddenly the fund industry is talking about liquidity – or lack of.
Most investors will have read about Woodford Investment Management’s well-publicised challenges around managing redemptions, which led to the suspension of dealing in one of the company’s funds. Then last Tuesday we read about Morningstar suspending the rating on a bond fund managed by H2O, citing concerns over the “liquidity of certain bonds”. H2O have since challenged these concerns, although investors and regulators are increasingly asking questions of their asset managers around liquidity risks.
In my own area – the corporate bond market – liquidity is something we spend a lot of time thinking about. In January I spoke on this topic at a leading bond market conference and published a paper titled Beating the liquidity freeze in bond markets.
To summarise my argument, since the Global Financial Crisis of 2007-2008 we have seen reduced bond market liquidity. There are two main reasons for this:
- The greater regulatory scrutiny of banks’ balance sheets following the crisis has had an inverse (and material) impact on the appetite of those institutions to hold bond inventory (and thus provide liquidity for the market); and
- Consolidation within the asset management industry has led to a greater concentration of holders (of individual bonds), which has increased the risk of liquidity bottlenecks in times of stress.
I argued in my January paper that central bank QE programmes have to some degree mitigated these risks, and indeed acted to support liquidity. However, the extent to which QE will alleviate the corporate bond liquidity conundrum on any longer-term view is, by definition, limited.
One of the (unintended) consequences of a price-insensitive buyer of corporate bonds (the central banks) has been to compress credit spreads, lower volatility and increasingly push the client base into the arms of a passive industry offering the allure of lower fees. The proliferation of passive bond funds – all seeking to construct essentially identical portfolios that mirror an index of limited size – will ultimately only exacerbate the liquidity problems in the corporate bond market.
So if we accept this is an issue and that it’s here to stay, how should we protect the consumer?
We argue that active management is the answer – with liquidity a key consideration within the investment process.
Quantitative tools can form a valuable part of any liquidity assessment. However, the reality is that liquidity is a fickle beast that does not readily conform to scientific analysis. Mathematical models cannot entirely substitute for experience and market knowledge. A careful assessment of an individual bond (and by extension its impact on an overall portfolio) should form part of every investment decision.