Kames Capital Conversations | Bond liquidity is back on the agenda

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Education

Bond liquidity is back on the agenda

By Adrian Hull, Head of Fixed Income

Liquidity is back on the agenda. GAM, Woodford, and most recently H2O have all faced much-publicised liquidity crises, and with them a flurry of doom-laden commentary. Bond market liquidity, of course, has been a cause for angst for a number of years. It is ironic that so much has previously been written about bond market liquidity whilst certain property and equity open-ended vehicles have seen the most challenge.

There are structural reasons why many investors need not be overly worried – but they should expect their managers to be considered and vigilant. We outline the three key areas where active bond managers can provide extra confidence in their assets, helping to ensure greater liquidity beyond a simple screen price.

Process
Fund managers’ process

Managers need to buy assets that are appropriate for daily liquidity funds. As a part of their investment process they need to understand how returns are made. Simply put, there are three levers any active manager can use to achieve “alpha” or outperformance. Duration, credit, and illiquidity premium. It is the last that is so opaque and has caused the most problems. In rates markets, do not expect Greek government bonds to be as liquid as the US Treasury market (and do not bucket their liquidity together solely as ‘OECD government’). For credit markets, do not expect an Italian bank to be as liquid as global behemoth JPMorgan (likewise, bucketing as ‘financials’ isn’t very telling). In an ever-decreasing yield environment it’s not wrong to seek extra return. But it is wrong to be blasé about the risk that less liquid assets bring to portfolios. A good process will have some fairly simple parameters. No private placements for daily liquidity funds is a good starting point. 

Corporate bond new issuance process

There are other things to look for that will make bond issues more liquid; the fixed income new issue syndication process is one. It is a regulated process that familiarises the many market participants with the issuer and launches a particular transaction. It will ensure a basic standard of documentation and listing on a recognised stock exchange – minimum ‘hygiene’ levels. The process provides transparency via the ‘book build’, a relative value discussion conducted by the investment banks who are paid to bring a deal to market. Whilst deal size is important (see below), and larger deal sizes will ensure inclusion in various bond market benchmark indices, deal size in itself can be a blunt indicator of liquidity. It is sometimes the largest issuers that can prove the least liquid, especially as corporate sentiment wanes – very much as we saw with GE last year. A number of deals have come to the market in recent years where the placement has been opaque, with the largest managers or sovereign wealth funds solely driving the transaction. A broadly-placed transaction will leave bonds in the hands of many managers with materially different economic motivations and differing price points.

Structure
Fund vehicles

This article is focused on open-ended vehicles rather than closed-ended vehicles (investment trusts) or segregated accounts. As the Woodford story shows, illiquidity in open-ended vehicles can hamper valuations in closed-end vehicles too, and as H2O showed, a lack of confidence in stock selection leads to a Morningstar re-rating. Open-ended vehicles could, theoretically, see all assets leave on-demand. The style, size and history of the investors in a fund remain important.

Issuers

Deal size was mentioned earlier, and typically the corporate bond market is focused on larger rather than smaller issuers. Investors in bonds issued by Nationwide Building Society will have greater investor coverage (and depth of trading) than smaller building societies. Likewise, Lloyds Bank versus Metro Bank. Moreover, deals sized above £200m will be eligible for index inclusion in the major sterling bond market indices – again pushing some investors to buy an issuer (especially those looking to replicate underlying indices). On the other hand, larger deal size and more issuance is often a negative to the bond market. Those companies that issue more debt often need more debt – and some of the motivations for issuance (share buybacks, poor investment decisions) are often warning signs for active managers. Increasing exposure to Technology, Media and Telecom (TMT) issuers in 2000 and financials in 2007 didn’t end well.

Expectations
Realistic outcomes

Bonds are known as boring, having none of the allure of rags-to-riches that characterise the headlines of equity start-ups. We buy bonds at 100 and aim to get that back with a commercial return along the way. Discounts or premiums represent buying and selling opportunities in corporate bonds – especially for an active manager. But expectations are bounded by that 100 redemption. There is no prospect of almost infinite returns, no tales of £1,000 becoming £1m. Active bond managers spend their time assessing which bond is better than the next, i.e. relative value. Again, simply put: do we prefer BT to Vodafone? Which gives us greater likelihood of outperformance? Running concentrated portfolios of 80-130 issuers typically means we are buying a small sub-section of the market – our preferred issuers that we believe will outperform. By definition, if we are successful there is more interest in buying the winners rather than the losers – and this has liquidity benefits. A focused portfolio means we are more aware of the price of our bonds, we are more active in booking profits and cutting loses. When we have inflows or redemptions we are able to re-assess the portfolio to where we want to position current risk exposures. We do not have the painful, rote, process-driven need to sell or buy a bit of everything that is an Index fund. By being focused we do not fill up investment banks’ balance sheets with odd-lot inventory; our trades are focused and relevant to both buyers and sellers, allowing a more effective transfer of risk.

Discipline

 Above all, we have a fiduciary discipline to ensure we act in the best interest of all stakeholders. That means ensuring a portfolio is the best response to how we see the future outlook for markets. There have been a number of occasions since, and during, the financial crisis where this discipline has meant we have weathered tougher conditions. Our bond funds have both materially expanded and contracted in reaction to changed investment conditions, criteria and customer demand through the years. We have satisfied daily liquidity requirements and our process is designed to do just that for today, tomorrow and the long term.

Summary

Liquidity is defined as seamless implementation of risk transfer at a price in time at a size. There are many variables which bond market participants must account for when they buy risk. Dangers lurk for those with the most exposure, and active management of risk transfer should remain an integral part of a manager’s process. Those that start with the idea that the market is less, rather than more liquid are better prepared for the inevitable but occasional liquidity gaps.

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