Liquidity Challenged

March 29, 2018

Liquidity Challenged Photo

Periodic bouts of volatility in the credit markets always serve as a good wakeup call about liquidity, or lack thereof. These periods are always instructive and cause one to reevaluate all positions in the portfolio. February and the first few weeks of March have exhibited the most volatility since the oil meltdown in 2016, interrupting an almost nonstop rally in credit spreads over the last year and half.

The corporate bond market is an over-the-counter market and has come a long way in terms of better transparency via TRACE (real-time trading updates). TRACE volumes, as seen in the chart above, and relatively narrow bid-ask spreads are often cited as evidence that liquidity is ample; but actually having to transact in the market suggests otherwise. Liquidity risk is an easy concept to understand, but difficult to define and more difficult to price. Typically we talk about it in terms of being able to sell a security within a short time frame at or near current market prices. Unfortunately, you should ignore that common sense definition, as the time frame and price at which one can execute is wide open to interpretation.

One of the lasting consequences of the financial crisis has been the de-risking of broker/dealer (Wall Street) balance sheets. These brokers no longer truly make two-sided markets – instead they act largely as intermediaries that will attempt to find buyers or sellers for bonds to make a transaction. As such the liquidity function they used to provide is marginal, particularly when markets get skittish. The issue gets compounded as you move down the credit spectrum. In good times, finding offers on bonds is difficult, while in bad times, finding bids is next to impossible.

What worries me is that we haven’t broached the driver of default rates and real pain in the market: a recession. Rather, the sell-offs we have had since the financial crisis have been short-lived and driven by exogenous factors, such as European Union break up concerns, rising interest rates and the rapid decline in oil prices. While they could have led to economic downturns, recession risk was not the primary concern. Also, at the same time broker/dealer appetite for risk has diminished, the size of the corporate bond market has quadrupled. The advent of exchange-traded funds (ETF) is another unknown factor potentially impacting market liquidity that hasn’t been tested in a recessionary environment.


Key Takeaway

I think you have to construct a portfolio with a strategic view on credit quality and duration, as well as individual securities’ liquidity measured by issue size. From there you can trade tactically based on credit events and macroeconomic views. However, as the next downturn begins to be discounted, you’re essentially stuck with what you own given the inevitable liquidity challenges that will ensue. Hence, I harken back to a line from a 1970s song, “If you can’t be with the one you love, love the one you’re with.”

Tags: Chart of the Week | Corporate bonds | Liquidity | Credit markets | TRACE

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