Maintaining focus in tight marketsLiquidity challenges may require a team approach
Sept. 9, 2016
While the U.S. bond market has faced a great deal of change over the past decade, in recent years, reduced liquidity has at times proven to be among the newest challenges for fixed income investors. Primary dealers like investment banks, which are among the key market makers in the bond market, tend to hold fewer debt securities on their balance sheets than before the global financial crisis of 2008–2009. As a result, it sometimes can be challenging for an investor to execute fixed income trades with major broker/dealers.
At Delaware Investments, I’ve had the privilege of working for nearly a decade with a highly capable and experienced fixed income team that prides itself on collaboration, communication, and relationships. We believe those are important traits for successful bond investors, essential for negotiating challenging markets.
Below, I’ll discuss some of our own processes and approaches to fixed income investing, as well as observations about the current workings of the market, which may provide insight for managing bond allocations in the balance of this year and beyond.
Recall the bond market is over the counter
The current liquidity-based challenges to trading conditions are due in part to regulatory changes designed to prevent crises of the magnitude of the global financial crisis. New regulations and laws aimed at financial reform such as Dodd-Frank have generally pressured bond market participants. As a result, investment banks, which are among the largest bond market dealers, typically hold less inventory day to day than they once did.
It’s important to recall that, in any market, buyers and sellers must be matched. The bond market has always been an over-the-counter (OTC) market (that is, not centralized on exchanges like stock markets) and, despite recent innovations like electronic trading platforms, is also traditionally a one-to-one market, where buyers and sellers are matched in part via telephone.
In our experience, reduced inventories have most frequently resulted in trading conditions that may best be described as “lacking fluidity.” Generally speaking, if fewer deals are available, that traditional market may not quite function as it does under the most ideal conditions, where inventories are plentiful.
The U.S. bond market has always been a broad one, so it’s important to keep in mind that reduced liquidity is a relative consideration. Today, market liquidity has not evaporated — far from it — but since the global financial crisis, there have been pockets of illiquidity that didn’t typically appear before.
Regardless of whether you’re a pension manager, a fund manager, a small wealth advisory team trading for client portfolios, or simply an individual investor, it’s worth being aware that investors and traders should be poised to meet these challenges head on, and also know what it may take to do so.
Keys for professional investing
In our view, a team that selects fixed income investments — whatever its size — could always benefit from being tightly knit. On a team, each person should understand his or her role in selecting investments, vetting companies or issues, and executing trades. That should be the case regardless of market complexities or size of the team. But especially during difficult periods, experienced teams that communicate well and work well together are more likely, we believe, to experience success, on balance.
At Delaware Investments, we know information sharing can be critical, and we value our physical proximity. For example, sector specialists are not siloed, and portfolio managers are generally found seated alongside others at our trading desk, an environment that encourages not only open communication but a team-based mindset. We think there’s value there, and would encourage this team-based approach for professional investment teams — regardless of whether it consists of three investors or 30.
Specialization and experience
For us, another advantage for professional investors can be found in specialization. We consider our team to comprise three main pillars: research, trading, and portfolio management. While that structure may be similar to those of other asset management organizations, we see value in filling positions on our team with experienced specialists who are enthusiastically committed to that role. While some in the industry may view the role of trader or analyst as a stepping stone to a more prominent career, we view traders and analysts as career positions themselves. One result, over time, is a team that is staffed with experienced specialists, dedicated to craft.
When it comes to navigating liquidity issues in the market, specialization and experience can be extremely valuable. For example, a less experienced trader might look at bond quotes on screen, see a reasonable bid-ask spread, and assume the bond is completely liquid, whereas a more experienced trader may review the same data and have a more nuanced understanding of what’s behind the numbers. The experienced trader might rely on past experience, in-depth knowledge of market conditions, and interpersonal working relationships with dealers on Wall Street, solidified over years. Perhaps most importantly, the experienced trader may be aware of how quickly liquidity can disappear on either side of a trade before execution. The senior trader weighs these considerations before moving forward on the trade or possibly determines, based on experience, that the trade isn’t viable.
Working in sync
Communications were deemed critical to our investment process long before the global financial crisis. But like many other professional investors, we witnessed the real value of information sharing throughout the crisis, when events either moved rapidly or had an effect across a number of fixed income sectors, such as high yield, commercial mortgage-backed securities (CMBS), and investment grade. We believe there are lessons to be drawn from that period for fixed income investors.
For one, that highly stressed period showed us the value of regularly monitoring for the overall effects of liquidity and liquidity risks at the portfolio level. In a fluid environment where liquidity conditions were sometimes changing rapidly, our team relied on a constant stream of information to update portfolio managers about liquidity status and event risk. While that time period was unique in many ways, the importance of staying proactive and diligent, in order to manage portfolios to within appropriate liquidity constraints during periods of tight or fluctuating liquidity, cannot be overstated. Identifying and understanding risk is a first step to managing it.
How an illiquid CMBS issue bore great significance
Another situation involving liquidity and the important role of communications was an incident in 2008 with a CMBS issue. Generally in this sector of commercial mortgages, it can take anywhere from three to six months to prepare the entire transaction for market, so in the interim, investment banks tend to hold the individual loan properties that will form part of the eventual deal. In this particular case, market stress built up, causing the dealers to realize that they would not be able to sell the bonds in the CMBS issue, and the deal was withdrawn. This information was immediately shared among our fixed income team members by a senior trader on our staff.
But it wasn’t simply that this information was communicated quickly to the entire team, as important as that was. The team immediately understood the event’s significance. That was key. Withdrawing the deal didn’t just mean lack of financing. Many of these commercial mortgage deals at that time were generally priced in the $1 billion plus range, so a large CMBS deal that did not get the necessary buyers had wider implications. The dealers were left with an enormous amount of commercial mortgage loans on their balance sheets. Because this event would have constrained the dealers’ balance sheets, we realized it could have likely forced them to also curtail risk and balance sheets in other asset classes, such as high yield and investment grade, causing reduced liquidity.
That was why information sharing was so important. This event could have been the canary in a coal mine for liquidity issues in sectors beyond mortgages.
With the right team, illiquidity can be an opportunity as well
Liquidity has gained a great deal of attention from market participants and observers, and at times perhaps deservedly so. Less fluidity can make the fixed income market less smooth. Yet, even these relatively illiquid periods can present opportunities. If some market participants are having a difficult time finding liquidity, particularly on assets that we think are attractive, it can be a chance for us to possibly obtain those assets at a less expensive price.
With our team structure, we believe we’re positioned to recognize and act on these kinds of opportunities. It involves the entire team. Our research analysts study and identify what they consider to be good companies and credits, and our traders not only turn to their working relationships with broker/dealers but rely on their experience to know whether the illiquidity is simply a short-term dislocation or something more systemic. Then, all of this information is fed to portfolio management to help facilitate decision making.
That is why, in our view, this team structure as a whole can be differentiating — in strong markets or stressed ones, during periods when liquidity is flowing, or when it seems to be drying up.
Trading is a key element of a 3-part team structure
The views expressed represent the Manager's assessment of the market environment as of August 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.
A bid-ask spread is the price difference between the highest amount a buyer is willing to pay for an asset and the lowest price at which a seller is willing to sell it.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
High yielding, non-investment-grade bonds (junk bonds) involve higher risk than investment grade bonds.
Fixed income securities and bond funds may also be subject to prepayment risk, the risk that the principal of a fixed income security may be prepaid prior to maturity, potentially forcing the investor to reinvest that money at a lower interest rate.
Asset-backed securities are bonds that are backed by pools of loans or accounts receivable that have been generated by credit providers such as banks and credit card companies.
Commercial mortgage-backed securities are bonds that are backed by pools of mortgages on commercial properties.