Finding an Oasis in a Bond Liquidity Drought

by Gershon Distenfeld, AllianceBernstein

Let’s not mince words: Liquidity is draining out of global corporate bond markets, and we doubt it’s coming back. But that doesn’t mean investors have to take their chips and go home. In fact, with the right approach, less liquid markets can offer some attractive opportunities.

Though it may seem like it sometimes, the liquidity drought isn’t a new phenomenon. Strict capital rules that global regulators have imposed on banks to make them safer have been steadily bleeding liquidity from the market for some time. This is because banks responded to the rules by cutting bond inventories at the same time that corporate debt issuance was rising. The result: fewer banks to act as buyers when investors want to sell (Display). Declining liquidity has been on our radar for years. But for many, it came into focus more recently when investors who had chased returns into overcrowded credit sectors found it difficult to exit when sentiment turned and everyone wanted to sell.

ETFs—Not as Liquid as They Seem
Many investors have reacted to these liquidity constraints by moving into passive exchange-traded funds (ETFs), especially in high yield. These are priced daily and can be bought and sold more easily than individual bonds.
But these vehicles may be less liquid—and more risky—than investors realize. That’s because their growing popularity means ETFs must hold an ever larger share of less liquid assets. And, as the Federal Reserve pointed out last month, if something should happen to cause the underlying asset prices to fall, it could spark a wave of forced selling.

Markets got a sneak preview of this in 2013 when the Fed announced plans to taper asset purchases, while signaling that it might raise official interest rates more quickly than expected. Investors reacted by yanking money out of bond ETFs.

In a Less Liquid Environment, Agility Matters
Some active managers, on the other hand, viewed the “taper tantrum” as an opportunity to buy attractive individual high-yield bonds when other investors were blindly hitting the sell button. For providing liquidity at a time of market stress, they were compensated with higher yields. ETFs, which passively track the entire high-yield market, couldn’t have replicated that strategy.

In our view, this ability to be agile and take the other side of popular trades is the key to staying afloat in less liquid markets. Managers who were able to profit from the taper tantrum were likely ones who had begun managing liquidity risk years ago, leaving them in a position to capitalize on liquidity-driven dislocations.

Here are four things investors should look for in asset managers if they want to turn illiquid markets to their advantage:

1. A nimble, multi-sector strategy. Liquidity can affect different sectors in different ways. So being able to move into and out of a broad universe of fixed-income assets is critical. If selling spikes and liquidity dries up in high yield, managers with a multi-sector approach can quickly and easily move to global investment grade or another sector where liquidity is more plentiful. Such a flexible approach would even allow strategic allocations to private credit sectors such as direct loans to medium-sized businesses.
2. Plenty of cold, hard cash—and derivatives. In illiquid markets, managers who keep more cash on hand than usual will be in a better position to swoop in when others are desperate to sell. As we’ve seen, that can mean picking up attractive, high-yielding assets at a discount. Of course, cash yields next to nothing, so to offset the potential performance drag, managers can tap the highly liquid derivatives market to create “synthetic” securities.
3. Trading prowess. The best traders can sniff out sources of liquidity and move swiftly to take advantage of them. That’s why it’s essential to involve them in the entire investment process. Traders who understand a portfolio’s objectives and an investment manager’s strategies are better equipped to manage liquidity risk and to act when opportunities arise.
4. Willingness to take the long view. Too much trading, on the other hand, can be costly. High trading fees, especially in high yield, can eat into returns. That’s why each new bond opportunity should be analyzed as if the bond will be held to maturity. What’s more, asset managers can’t rely on liquidity being available when they need it, so they might not be able to sell at a given investment horizon. If holding a particular security to maturity doesn’t look attractive in today’s environment, it might not be worth buying at all.

In our view, investment managers who take these guidelines to heart can help increase their potential to both manage liquidity risk—and profit from it.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

Gershon Distenfeld is Director of High-Yield Debt at AB (NYSE:AB).

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