H2O, GAM, Woodford. Three fund managers that all faced crisis due to liquidity. Or rather, a lack of it. It’s not surprising, therefore, that the trade press has been filled with panicked comment on bond market liquidity.
Last Wednesday, the European Single Market Authority (ESMA) added fuel to the fire, releasing a report on their liquidity stress-testing. It was actually relatively benign, saying “The results show that overall, most funds are able to cope with such extreme but plausible shocks, as they have enough liquid assets to meet investors’ redemption requests”. It was not entirely rosy, however, noting “pockets of vulnerabilities” in certain asset classes where some funds would see liquidity dry up in the event of a fire sale, and would struggle to sell assets in a hurry. Naturally the press seized upon this and continued to work itself into a tizzy.
Illiquid assets bring a yield premium with them, and in a world of low yields these have become increasingly attractive. Many funds are snapping them up to boost returns. But it is vital to remember that the extra yield is in return for extra risk. Those who forget it may join H2O, GAM, and Woodford in realising that liquidity disappears at the very moment it is needed most.
At Kames, consideration of liquidity is absolutely key when evaluating a potential investment. We do not use illiquidity as a source of alpha. Instead, by maintaining a disciplined and rigorous investment process, we look to avoid those stocks that will become untradeable during a crisis. By keeping our funds agile, our clients get to sleep a little easier.
For more of our thoughts on bond liquidity, look here