David Hanna – Senior Portfolio Manager, Global Fixed Income
Recent events in the absolute return fixed income investment landscape bring renewed focus to the role of this investment style in portfolios. Our view has long been that absolute return fixed income can provide an alternative to traditional bond funds, but should not compromise on the fundamental role of fixed income: to provide liquidity and capital preservation within a broader investment portfolio. In recent years we have seen evidence of ‘reaching for yield’ amongst some absolute return investors, with significant allocations to high beta credit sectors, private credit, and increased allocations to complex securities. Many of these strategies have worked particularly well over the last decade of ‘easy money’ central bank support, but might be significantly less suited to an environment of higher volatility and less accommodative monetary policy.
There has also been evidence that investors are again forgetting the value of liquidity. Liquidity is one of the pernicious problems facing fixed income investors. Ignoring liquidity costs will in most market environments generate small, consistent positive returns, at the risk of significant losses during stress: just when the protection of fixed income is needed most.
Divergent performance in recent months (and fund closures in specific cases) indicate that some investors have stretched too far to generate returns in a low yield, low spread environment. It is paramount for investors that this allocation is fit to do its job at times when the rest of your portfolio may be under pressure. As such, we think now is a good time for investors to reflect on the capital preservation characteristics of fixed income, and in doing so, ask whether their portfolio liquidity may actually be a mirage?
How markets behave with abundant liquidity
Long periods of positive asset performance and market stability tend to encourage investors to reach for one of the few sources of yield remaining: the liquidity premium. This was most notable in the years leading up to the financial crisis, where credit markets paid almost no attention to liquidity, and has been increasingly evident in recent years as the reward for taking credit risk has fallen sharply. We have seen a gradual erosion of liquidity in the market, ranging from increasing interest in private credit, growth in complex products, to renewed use of leverage amongst investors and the growth in structured deposits. Investors’ focus on liquidity has waned over the last decade of loose monetary policy despite credit market growth and dealer balance sheet sizes indicating that liquidity is likely to be flightier than ever.
Chart 1: US dealing inventories (Corporate & ABS)
Chart 2: USD credit outstanding
Source: Chart 1: US dealer inventories (NY Fed, Macquarie); Chart 2: USD credit outstanding (Bloomberg, Macquarie)
The buyer base in credit markets has also gradually become less diverse, and with a shorter-term focus. The increased holdings by mutual funds, ETFs (generally offering daily liquidity) and by foreign buyers all point to a lower allocation to long term, hold-to-maturity type buyers. ETFs in particular have exploded in most asset classes in recent years, including in markets such as high yield and emerging markets that have historically offered lower liquidity.
Chart 3: US corporate bond outstandings by owner
Source: Citigroup, Macquarie *Although described as ‘household’ in flow in of funds, series likely dominated by hedge fund
Chart 4: Growth in US high yield ETFs
Source: Bloomberg, Macquarie
The result is that the reward for taking liquidity risk continues to fall. Using our global relative value model, we can estimate the extra yield paid to investors for buying ‘off the run’ securities (those that are not the most recently issued), which have tended to be less heavily traded and less liquid. The extra yield for buying ‘aged’ securities (based on issuance year) remained relatively static into late 2017 (even as overall credit spreads tightened) but has recently fallen significantly as investors have sought out the last remaining pockets of extra yield.
Chart 5: The disappearing liquidity premium | US IG spreads and additional yield
Source: Bloomberg, Macquarie
Liquidity is an integral part of long-term fixed income performance
Our belief that liquidity is key to fixed income performance is supported by research that our team first performed more than a decade ago on liquidity in credit markets and which we updated in 2014, with confirming results. This research showed us that liquidity management is key to performance in credit investing, and in fact compensation for liquidity is a more important consideration than credit risk when buying investment grade securities.
Less liquid securities come with a number of features – that can be perversely attractive. Their lower liquidity often brings a modest illiquidity premium, but they bring a secondary, less obvious feature: their pricing is marked less reliably as they are thinly traded, meaning illiquid securities can actually appear much more stable than a comparable liquid holding but the reason is simply the security has not been traded. But illiquid securities are likely to perform worse in times of market stress (when capital preservation really matters), so the ‘stability’ of marked prices is illusory. To compound the issue, investors will naturally sell what they can (not what they necessarily should) in times of stress, so when it comes to eventually selling the illiquid holdings the cost of sourcing liquidity can be severe.
So ignoring liquidity can generate apparently consistent alpha, at the risk of significant losses during stress - the classic ‘picking up pennies in front of a steamroller’.
Simple steps to managing liquidity
We continue to maintain our underlying philosophy of capital preservation in all the fixed income styles we manage which includes a significant focus on liquidity. This focus on liquidity involves a total portfolio approach combining both the desired risk profile with expected liquidity requirements. A portfolio is constructed with both return targets and liquidity profile in mind as each new security is added.
In the current market environment, that means gradually moving up in quality as tighter spreads reduce the value on offer, reducing allocations to higher beta sectors such as high yield and emerging markets, and generally building and favouring liquidity - this can be by increasing cash holdings, moving to portions of the market with proven liquidity through the cycle, and other similar changes. Generally low spreads indicate to us there is limited return for risk on offer, and we believe the value of liquidity has again become increasingly under-estimated by most investors.
Not every holding in a managed fund has to be highly liquid, but with many funds offering daily liquidity even a relatively small holding of illiquid securities can become problematic in the case of investor outflows. Portfolio managers will naturally look to sell more liquid holdings in order to fund outflows, and this in turn tends to increase the level of illiquid holdings remaining. What can investors look for as potential indicators of future liquidity problems? We believe significant weightings to lowly or unrated securities, heavily structured securities, use of leverage, or overly complex holdings can offer warning signs that the manager is relying on liquidity premiums to increase returns.
Investors are attracted to the absolute return investment style because of the specific role that they expect it to play in their portfolios. It is important to understand the nature of the strategies that managers are using to generate returns as this will help them understand whether the strategy is suitable for their purposes. Instances where traditional return generating strategies are being replaced by what is essentially trading illiquidity for incremental increase in return, should be a warning signal.
Liquidity and a focus on capital preservation are key to fixed income investing, and adequate compensation for risk is paramount to long term fixed income performance and making sure that you are receiving your expected absolute return. Make sure your expected liquidity is not a mirage!