Remember the story of the blind men and the elephant? One man grabs the tail; another, the trunk; another, a tusk—yet nobody knows what the animal looks like. Liquidity risk is like that elephant. It’s easy to misunderstand—and mismanage.
It’s not that investors are unaware of the risk. Bond managers are paying more attention to liquidity, and some of what they’re doing and recommending to their clients is good. But as we’ve pointed out, there are many reasons why liquidity has seeped out of the bond market—and several trends that could make the situation worse.
Managers who don’t understand all the moving parts or who take a piecemeal approach to managing the liquidity risk in their clients’ portfolios are playing a potentially dangerous game.
So what do we mean about not seeing the big picture? Here are just a few examples.
Focus on Traders, Not Trading
Some asset managers see the decline in bond market liquidity, first and foremost, as a regulatory issue. In other words, they attribute it to new rules that require banks to hold more capital and limit their ability to trade for their own profit.
No doubt, these changes have reduced market liquidity, though they’re not the only force at work. Even so, many asset managers say they can cope by deepening their pool of potential trading partners. This means using smaller brokers to complement the stable of more traditional liquidity providers, such as banks and primary dealers.
There’s nothing wrong with that approach—but it doesn’t go far enough. In our view, the best thing firms can do when it comes to sourcing liquidity is bolster their own trading ranks.
With banks playing a smaller role in the bond-trading business, it’s more important than ever to have skilled traders with the expertise to find liquidity when it’s scarce and take advantage of the opportunities it can offer. In the past, traders at buy-side firms tended to simply execute orders. That approach won’t work anymore.
Over time, more electronic, “all-to-all” trading platforms that can match large orders among a bigger pool of buyers and sellers may help address these issues. But in-house trading expertise is critical.
Cash: Opportunity Cost or Opportunity?
Asset managers recognize the wisdom of keeping cash on hand in a low-liquidity environment. But too many view it simply as a way to meet redemptions should large numbers of investors suddenly want their money back.
Being able to meet redemption is important, of course. But focusing only on this overlooks another benefit that cash confers: the ability to act quickly to take advantage of liquidity-driven dislocations. When liquidity dried up during the “taper tantrum” in 2013, investors who avoided crowded trades and kept some cash on hand were able to swoop in and buy assets at attractive prices. Think of it as compensation for providing liquidity when so many others needed it.
Of course, with interest rates as low as they are, there’s an opportunity cost associated with cash. But there’s a way to partly offset that performance drag: use relatively more liquid derivatives to get exposure to “synthetic” securities.
Look Beyond Volatility
Having endured the extreme volatility of the global financial crisis, it’s no surprise that many have embraced “risk-aware” strategies. These use volatility-managed or value-at-risk (VaR) techniques in an attempt to provide downside protection.
We can see why this approach may seem attractive at first blush. But the number of investors using these strategies has exploded in recent years. That means a lot of people are doing the same thing at the same time. Asset managers who see these strategies as a panacea may not realize that they can make a liquidity crunch worse.
Why? Because when volatility rises, managers who use VaR-based strategies generally have to sell assets to bring their portfolios’ risk back in line. That can be bad for individual returns (you’re selling when prices are falling) and for broader market liquidity (you’re selling when everyone else is, too).
It’s always useful to keep an eye on volatility when managing risk. But a better approach, in our view, is one that allows investors to buy assets when they cheapen and sell them when they get expensive. This can only be done by lengthening one’s investment time horizon.
During times of high volatility and low liquidity, this may mean sitting tight, turning a blind eye to price declines and waiting for the storm to end. But in the long run, we think this approach is more likely to lead to better investment returns.
Seeing the Big Picture
Navigating today’s bond market requires a thorough understanding of liquidity dynamics—both the risks and the potential opportunities. We think managers who are just feeling around in the dark—like one of the proverbial blind men examining the elephant—may struggle to keep their clients’ portfolios afloat.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
Opinion column by Douglas J. Peebles, Chief Investment Officer and Head—AllianceBernstein Fixed Income, and Ashish Shah, Head – Global Credit.