Our approach to an environment of constrained market liquidity
December 12, 2014
Liquidity is a financial institution’s capacity to meet its cash and collateral obligations without incurring unacceptable losses. Liquidity risk stems from the lack of marketability of an investment that cannot be bought or sold quickly or in enough size to prevent or minimize a loss. This risk is typically reflected in dealers’ unwillingness to take on risk, wider bid-ask spreads, lower levels of trading activity, and lack of market depth (larger price movements) during periods of stress. This can be evident in the market as a whole or confined to specific sectors or asset classes.
Several factors are constraining market liquidity today
Dealers’ ability to warehouse risk has declined as a result of higher capital requirements on trading assets and tighter risk limits, as both Basel III and the Volcker Rule have been implemented. Basel III regulations not only impose constraints on leverage but include liquidity-coverage ratio requirements that favor liquid assets such as Treasurys and agency mortgage-backed securities (MBS) over AA-rated bonds and other lower-rated securities. Similarly, the Volcker Rule restricts proprietary trading, but Treasurys, government-sponsored enterprises (GSEs), and municipal bonds are exempt.
As a result, dealer inventories have been scaled back in certain sectors. For example, dealer holdings in corporate debt are currently at their lowest levels since 2001 (see Chart 1). Similarly, assets under management (AUM) across all domestic fixed income sectors at buy-side firms since the global financial crisis have far outpaced those of dealer holdings (see Chart 2, net AUM is for U.S. bond and hybrid funds, excluding exchange-traded funds (ETFs) and hedge funds). Limited trading volumes among agency MBS and corporate bonds have been one consequence of dealers’ now-limited role. Average daily trading volume as a percentage of market size for agency MBS and corporate bonds (both investment grade and high yield) is down 37% and 54%, respectively (see Chart 3).
Chart 1: Dealer holdings in corporate debt at their lowest since 2001
Source: Federal Reserve Bank of New York
Chart 2: Dealer holdings of domestic bonds currently a fraction of those of buy-side firms
Source: Federal Reserve Bank of New York, Securities Industry and Financial Markets Association (SIFMA), and Investment Company Institute (ICI)
Chart 3: Trading volumes are down across agency MBS and corporate bonds
Source: SIFMA and Barclays Live
Central banks’ low interest rates and quantitative-easing policies, which have pushed investors into risky assets, have created another important dynamic that has taken place within the fixed income markets in recent years. This has led to a compression in risk premiums (as Chart 4 highlights), and has left markets more vulnerable to shifts in flows, especially since retail investors now play a bigger role in credit markets than they did in 2008 (see Chart 5). Fortunately, bid-ask spreads have remained well behaved even during periods of stress (see the so-called “taper tantrum” of May 2013 and, more recently, outflows from the high yield market in summer 2014), but we believe that could change if volatility picks up on a more sustainable basis.
Chart 4: Fund flows versus spreads in the investment grade (IG) and high yield (HY) bond markets
Fund flows have historically been a relevant factor for spread movement.
Source: EPFR and Barclays Live
Chart 5: Retail investors comprise a significant portion of today's credit market
Since 2008, the ownership structure of U.S. credit has changed. Retail ownership is more significant today.
Source: Federal Reserve Board
Chart 6: Bid-ask spreads within the IG and HY markets remain tight
MarketAxess bid-ask spread indices (BASI) for high grade and high yield corporate bonds
Bid-ask spreads in corporate bonds have been well behaved, generally moving in lockstep with each other and remaining within a tight spread over the past decade.
How do we track the evolution of this new risk metric?
Citigroup and Bank of America Merrill Lynch provide two useful gauges of liquidity based on market and flow indicators (see Chart 7). Levels greater or less than zero indicate more or less stress than is normal. Currently, market liquidity indices remain well behaved, but readings above 0.5 are important to monitor going forward.
Chart 7: Liquidity metrics remain calm
Implications for our clients
Given today’s liquidity-constrained conditions, we believe medium-sized managers operating with a longer-term, bottom-up credit research style are better positioned to exploit market inefficiencies by harvesting elevated illiquidity premiums and avoiding heightened transaction costs through a low-turnover approach that seeks to limit credit mistakes. Monitoring concentration risk and managing liquidity can be achieved through each of the following techniques:
- Maintaining adequate liquidity pools in client portfolios (Treasurys, agency MBS, and high-quality corporate bonds).
- Keeping a liquid name list within sector-specific portfolios such as high yield corporate bonds
- Performing portfolio stress testing.
- Ongoing maintenance of sell-side relationships for information flows.
We undertake each of these steps both in today’s liquidity-constrained world and within the risk-aware approach we regularly employ at Delaware Investments.
The views expressed represent the Manager's assessment of the market environment as of November 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. The Funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Funds may be prepaid prior to maturity, potentially forcing the Funds to reinvest that money at a lower interest rate.
High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.
Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.