The outlook for liquidity in bond markets has been a topic near the top of investors' agendas for some time but there are ways investors can stay afloat and possibly even profit from the current environment.
Here, the two fixed income specialists outline the five ways in which asset allocators can adjust and adapt their investment process in order to manage liquidity risk.
‘Isolating allocations into single-sector funds - high-yield, emerging-market and so on - is risky business when liquidity is low,’ Peebles and Shah said in a commentary piece on their latest investment outlook. ‘If liquidity dries up in one sector, investors may not be able to trade during times of market stress.’
The two managers, who are named across several fixed income funds at the US investment firm, said they prefer to take a holistic and dynamic multi-sector approach that taps into a broad range of fixed-income assets.
2. Avoiding the crowds
The herd trend markets have been experiencing in the current low interest rates environment pushed asset prices higher, according to the pair. ‘In many cases to levels where we no longer think investors are being compensated for the risk they’re taking,’ they said.
‘We think it’s better to avoid the crowd and make decisions based on value, not popularity. The ability to take the other side of popular trades can be a crucial advantage.’
3. Cash and derivatives
Investors who don’t follow the ‘crowds’ will be in a position to buy assets at lower prices, but this requires cash at hand to take advantage, the managers said.
‘Think of those investors who used the ‘taper tantrum’ to buy attractive bonds when everyone else was hitting the Sell button. Sure, cash has yielded next to nothing for the past seven years, and keeping too much of it on hand hasn’t boosted returns,’ they added.
Peebles and Shah said they are using more liquid derivatives to get exposure to ‘synthetic’ securities.
4. Lengthening investment horizons
There is no guarantee liquidity will always be there when it is needed, so it’s important to analyse every new bond opportunity as if it was going to be held to maturity, according to Peebles and Shah.
‘But if we’ve done our credit homework well, we should end up with a portfolio of sound long-term investments that can weather periods of market turbulence.’
They added, as long as the bond issuer doesn’t go bankrupt, investors will earn a steady stream of interest and get their principal back when the bond matures, regardless of daily market fluctuations.
5. Strategic allocations to private credit
Peebles and Shah’s fifth and final point is on making direct loans to middle-market companies and investing in privately originated commercial mortgages. ‘Because these investments are less liquid than more traditional fixed-income assets, they offer considerably higher yields.’