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Are bond managers risking returns for liquidity?

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It will not have escaped the notice of many investors that bond market liquidity is tight. Fixed income fund managers have – largely – acknowledged the problem and outlined the steps they are taking to deal with it. But this generates the new problem of whether steps taken to mitigate liquidity problems end up denting the overall return to investors.

Most fixed income managers would admit there is a mismatch between the liquidity they offer investors – usually daily dealing – and the liquidity fixed income markets provide.

The reasons behind this have been well covered, but primarily focus on the withdrawal of investment banks from market-making activity and the super-loose monetary policy pursued since the financial crisis. Although there are initiatives being discussed, there is no immediate resolution in sight.

So for the time being, managers must deal with the problem as best they can. Some managers may be holdings high cash weightings to meet redemptions, others may overlay funds with derivatives strategies – to shift positions more easily than buying and selling the underlying securities – while other groups have even used equities as a source of liquidity.

The question is the extent to which these moves change the performance profile of the funds. To what extent are fixed income managers having to compromise their style and adapt their ideas to meet liquidity constraints?

Axa WF Global Strategic Bonds fund manager Nick Hayes says liquidity may be in the headlines but is not a new problem. “Fixed income is an over-the-counter market and liquidity is always a consideration, particularly when you are buying credit, high yield or emerging market debt, but it has been happening for many years and most managers are aware of the risks.”

Kames Capital fixed income product specialist Adrian Hull says it is clear the extent to which it can compromise an investment process depends on the size of the fund.

“If you are worried about liquidity to the extent that you are holding 10 per cent of the fund in cash, then that fund has a drag on performance simply because it is not receiving the coupon on those bonds.

“Liquidity should not prevent, say, a corporate bond manager from investing in corporate bonds.”

Hull believes the danger for larger funds is they become increasingly unfocused. They have to take liquidity where they can get it, which means participating in almost every bond issue. In this way, quality is compromised.

Hayes agrees, saying while large is not necessarily bad – there can, after all, be small and illiquid funds as well – a large fund full of illiquid instruments will see its flexibility compromised.

Others have suggested liquidity may also impact on performance in less obvious ways. At times of outflows, for example, managers are forced to sell their most liquid holdings. In the recent sell-off, if a fund manager had an overweight position in energy stocks, they could not have exited that position to meet redemptions because there were no buyers for energy bonds.

The manager would therefore have had to sell the more liquid parts of their portfolio, leaving them with an even greater overweight energy. This might be considered an uncomfortable overweight at a time when energy prices are sliding.

Of course, some may be holding very liquid instruments for reasons other than liquidity.

Tenax Absolute Return Strategies fund manger James Mahon says: “Our fixed income fund is £200m so it doesn’t have the same liquidity constraints. That said, we are holding a considerable weight in floating rate notes, which are considered near-cash, but this is more because we believe rates should be moving higher in these circumstances.”

What about the use of derivatives? Certainly many managers are overlaying derivatives strategies on their funds, but JP Morgan Income Opportunity fund manager Bill Eigen argues liquidity is unlikely to be the only reason for doing so. He argues that it is also a useful way to take shorter term positions or positions that aren’t possible in conventional markets.

He says: “In many cases the bid offer spread is so wide it is not worth trying to trade. The transaction costs are extremely high. We would use derivatives, such as [credit default swaps] to implement ideas instead.

“If I wanted to take a position that Venezuelan bonds would not default in the next nine months, I can’t do that because there are no Venezuelan bonds shorter than three years. I can sell six-month protection on Venezuela credit default swaps, which will reflect the  nine-month view.”

Hayes argues derivatives do not help particularly with the mismatch between the liquidity offered to investors and that available in the market. “You cannot sell derivatives to meet redemptions from a fund.”

He says all derivatives can do is “free up” liquidity for elsewhere in the portfolio.

Eigen points out different times are coming for fixed income. “We haven’t had a bear market in US fixed income for 33 years and that makes some people think they are invincible.”

Most fund managers recognise the limitations a lack of liquidity brings and manage their funds accordingly without compromising their process excessively.

The problem comes for larger funds, or those investing in more esoteric parts of the market.

In reality, the problems around liquidity are a reflection of the bond market as it exists today. At a time when the bull market for bonds is in its dying hours, managers need to be more creative in the way they implement their ideas, but investors must ensure they trust them to be creative while still delivering as promised.

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