Does bond liquidity affect high yield more?
July 29, 2016
In December 2015, a mutual fund company abruptly halted redemptions in one of its funds — a high yield debt fund — to forestall having to dispose of assets at heavily discounted prices. This was a highly unusual event, in that a U.S. mutual fund had stopped investors from obtaining redemptions without first officially seeking relief from the Securities and Exchange Commission (SEC). The event was viewed by many as resulting from lack of liquidity in the bond market, and it caused a ripple effect through the industry with some questioning whether liquidity issues may have extended beyond this fund, and whether they were affecting the high yield bond market in particular.
The SEC, perhaps indicating its focus on market liquidity, responded swiftly to the redemption halt. Within weeks, SEC examiners sent letters to funds holding similar securities — mainly distressed debt and bank loans. This targeted effort by SEC examiners, whose role is to ensure compliance with the agency’s rules, followed other moves to help verify that funds are able to meet the duty to return cash within seven days to those investors seeking redemptions.
Why liquidity can be an issue in the bond market
Liquidity has long been a critical factor in the bond market, essential to daily market function across the board. Market liquidity, of course, is a primary ingredient for creating wholly efficient markets. Many bonds are not traded on centralized exchanges, like stocks are, but instead tend to use the personal connection of over-the-counter (OTC) trading. Any hint of illiquidity could make trading difficult in the bond markets, where matching of buyers and sellers often takes place manually.
Having a reasonable sense of liquidity, and a feel for a potential trade’s overall supply-and-demand dynamics, are critical factors for market participants seeking efficient pricing. Any sense among individual bond traders of less than fully liquid market conditions may potentially have a dampening effect, adversely impacting trade timing and overall market action — although sometimes a period of illiquidity could present better value buying opportunities.
In the years following the global financial crisis of 2008–2009, prime liquidity conditions have become compromised at times, attributable in part to changes in regulations and tighter bank risk controls that have dampened the risk appetites and shrunk the balance sheets of the investment banks that often are in the role of primary dealers in the market.
Recent spates of illiquidity in bond markets have prompted some investors, according to two of our portfolio managers, to focus on the perceived effects of illiquidity among high yield bonds, especially because these are perceived as riskier investments, based on credit. "High yield historically has been less liquid than investment grade," said Adam Brown, a senior portfolio manager of high yield corporate bond portfolios. "By definition it’s a riskier part of the market and there’s a smaller buyer base. Layer on the regulatory considerations and the result has been more liquidity constraints."
Steve Czepiel, a senior portfolio manager for municipal funds including high yield portfolios, said he has seen liquidity evaporate a handful of times in recent years, events that were more pronounced in the high yield market. "These pockets of illiquidity, however, have generally led to buying opportunities for us," he said.
"The high yield muni market is relatively small, and demand has been fairly constant and has been well supported by many retail investors," Czepiel said. "Given the low yield environment, these individual investors have shown increased interest in high yield muni bonds."
Liquidity can affect different types of high yield investments differently
In addition to the mutual fund redemption issue of December 2015, other events that served to dry up the market included the so-called "taper tantrum" in 2013 (when yields rose sharply over concerns that the U.S. Federal Reserve might reduce its bond purchasing program and raise interest rates rapidly) and the bankruptcy of Lehman Brothers, which is considered one of the catalysts for the global financial crisis.
Both Brown and Czepiel noted that, in their opinion, liquidity issues in high yield bonds can be distilled into two distinct issues. First, much can depend on the type of high yield bond in question, because the sector is not homogenous. The second point relates to the high yield municipal market where liquidity issues tend to be more episodic, rather than systemic.
The effect that a high yield security can have on a liquidity event can be found in the example of the mutual fund that halted redemptions in December 2015. That fund was replete with distressed debt, both bonds and other debt securities, having about two-thirds of its assets in those securities. "That’s a smaller, much more difficult part of the market," Brown said. "You’re talking about distressed debt that tends to be thinly traded. Therefore, that can have much larger potential for liquidity risk, especially in times of stress." The rest of the high yield debt market is generally more liquid, he said.
High yield municipal bonds make up a small slice of munis, accounting for less than 15% of the market, Czepiel said. "In this space there are usually few surprises," he said. "Problems such as Detroit and Puerto Rico — which are two recent examples of municipal bonds with default problems — sometimes have the potential to be identified in advance. In many instances, we can identify problems and liquidity issues emerging well before they come into play, and we can seek to take appropriate action." Further, Czepiel said that there is a difference between the risk profile and liquidity of certain revenue-based and general-obligation bonds. General-obligation bonds are backed by the taxing authority of local and state governments, but that doesn't necessarily mean that general-obligation bonds should be viewed as safe havens, he said. In the same way, while some revenue bonds are very high quality, they can pose some additional risk. Revenue bonds depend on relatively narrow sources of revenue to repay debt, which then can be earmarked for specific projects.
Still, Czepiel noted, defaults of high yield municipals are less prevalent than those of speculative corporate bonds over time. Between 1970 and 2013, for example, the default rate of high yield muni bonds was 6.5%, far below the 33.1% rate of default for speculative corporate bonds, according to Moody’s Investors Service.
Vigilance with liquidity
In Czepiel's view, any liquidity issues in high yield municipal bonds can generally be expected to be episodic or seasonal in nature, and have not appeared to be systemic. "Overall, market liquidity has remained strong and demand for yield has remained high in this low interest rate environment," Czepiel said. "In our experience, liquidity has not been an issue."
Because of regulatory changes that have been imposed since the financial crisis, liquidity may be better than it has been in the past year, Brown said, but it still is down relative to where it was several years ago. As a result, for corporate high yield investments, Brown said that he needs to remain vigilant about the liquidity characteristics of the holdings in the portfolio.
"I look at each and every security from the standpoint of whether or not I would be able to sell it during a time of stress," Brown said. That can require open lines of communication across the fixed income team, among research analysts, traders, and others in portfolio management. "We don’t operate in silos at our firm," he said. "So if there are any remote concerns about the liquidity of a specific security, we will be in close communication with each other about it, so we can take the steps we believe we need to take to protect the liquidity of the portfolio."
The views expressed represent the Manager's assessment of the market environment as of July 2016 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. The investments referenced herein may not be suitable for all investors.
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