Eaton Vance: Managing liquidity risk

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Sep 02, 2015, 10:11 ET

BOSTON, Sept. 2, 2015 /PRNewswire/ --

SUMMARY

Investors commonly confuse increasing liquidity costs with "illiquidity" – a view that is potentially misleading.
Market prices and liquidity costs continually fluctuate – understanding those dynamics can better position fixed-income investors to achieve their goals.
The cost of liquidity and price volatility have been increasing since the 2008 financial crisis, as risk has been transferred from the banking system to investors in the capital markets.
Eaton Vance's global income team manages liquidity risk by focusing on individual risk factors rather than just securities that package multiple factors together.

Since the end of the 2008 financial crisis, fixed-income markets have had higher liquidity costs and greater price volatility. This is largely a direct result of post-crisis financial reform, as actions taken by central bankers and regulators effectively transferred risk from the banking system to investors in the capital markets.

This paper outlines how liquidity risk can be understood and managed. The Eaton Vance global income team believes that liquidity risk, like interest-rate and credit risk can be best managed by focusing on and trading in those individual risk factors rather than just securities that package multiple factors together. First, we address some common misconceptions about liquidity.

Three misconceptions about liquidity

From our perspective, as long as there is a buyer and a seller for a given security, it is liquid. A separate, important question is the price of that liquidity – most commonly expressed as the spread between the bid and the offer.

Spreads can widen in sectors or securities for any number of technical or fundamental factors, and such widening increases liquidity's cost. But that should not be confused with illiquidity, which has been a very rare, transient occurrence in major U.S. capital markets. In the absence of a true liquidity crisis, most concerns about "illiquidity" are unfounded, and describing securities as "illiquid" can be potentially misleading. Here are three common misconceptions:

The price of liquidity is fixed – Liquidity is a good and, like all other goods, the price varies under different scenarios and over time. Some investors, however, apparently believe that it is unvarying. Thus, when bid/offer spreads increase for a security, it is mistakenly (in our opinion) deemed "illiquid."
Liquidity costs too much – Some investors believe a security is "illiquid" when the bid/offer spread exceeds their willingness to pay the cost. While undoubtedly painful and unfortunate for an individual investor, the price of liquidity is market driven. Liquidity is available for those prepared to accept the premium required to buy or sell.
Liquidity varies by bond position size – Some investors define liquidity based on how long it would take to sell their entire position in a particular security. The per-unit cost of liquidity for larger positions may be greater than for smaller ones, but it is not the liquidity that changes with position size, just its price.

Why liquidity costs are increasing

This upward repricing of liquidity in recent years is due to several factors, the most significant of which are new banking regulations that have been implemented since the financial crisis.

Banks have historically been the major provider of liquidity to fixed-income markets in their role as market makers – institutions that act as willing sellers or buyers of securities on demand. However, since the crisis, reforms such as the Dodd-Frank Act and the Volcker Rule have compelled dealers to reduce leverage and increase capital, which has made holding bond inventories more expensive. In many cases, market-making has become cost-prohibitive for banks.

While nonbank investors are the ultimate buyers and sellers of nearly all securities, bank market-making has served to bridge the timing and information gaps between when a willing seller and a willing buyer were in the market. Of course, banks have never provided this function as charity – it happens when and where they believe their trading desks have a high probability of generating an attractive rate of return. That said, their bridge has been deteriorating for years, even before the crisis.

Paradoxically, the excess liquidity pumped into the financial system by central banks has been another major factor behind the increasing cost of liquidity in fixed-income markets. The dollars in the portfolios of asset managers, insurance companies, and other institutions have been seeking yield and have increased demand for all fixed-income assets.

This large buyer contingent has overwhelmed remaining bank intermediaries. Dealers looking to meet demand for a bond often do so by selling one they don't have (i.e., shorting it), and then covering the position with a subsequent market purchase. But with surging prices for bonds, the risk for dealers increases because covering their short positions gets more costly. Thus, they have sought to reduce that exposure by widening bid/offer spreads. Put another way, the spread widening reflects the risk of a one-sided market.

How we navigate the New World

Fortunately, there are a number of techniques available to manage liquidity repricing risk. Individual bonds typically expose investors to multiple risk factors, including interest rates, credit spreads, currency, etc. However, these risk factors can be traded in isolation to limit the potential of undesired exposures during periods of elevated liquidity re-pricing.

A long bond position, for example, leaves the portfolio exposed to both interest-rate and credit risks. If liquidity becomes more expensive due to a sudden rise in interest rates, then an unhedged portfolio will experience losses. Assume, however, that the portfolio manager believes the issuer is strong and highly creditworthy. The manager can retain the credit risk and hedge out the undesired interest-rate risk, typically through futures contracts or interest-rate swaps.

Another threat to bond liquidity can come from an issuer's deteriorating credit situation. A manager concerned about credit risk can reduce that exposure with a credit default swap on the individual issue. If a swap on the particular name is not available, then a credit default swap index or even shorting the issuer's stock could also provide a hedge. The hedge may not be perfect (it introduces basis risk), but it may be more effective than continuing to build up losses as the liquidity cost of selling keeps getting greater.

Also, the market is evolving to meet the demand for cheaper alternatives to bank-provided liquidity. Technology providers are offering new methods to access liquidity, including all-to-all trading, peer matching and scheduled liquidity auctions. The opportunity now exists for innovative asset managers to take advantage of these new tools to access liquidity directly from other asset managers and to do so at a much lower cost.

Don't mistake changing prices for a liquidity crisis

Many worry about a coming liquidity crisis without fully understanding what that would mean. Higher liquidity costs have indeed often been accompanied or followed by market price declines, but the two are independent concepts. Investors can benefit from some useful distinctions between a true liquidity crisis and routine market price volatility:

Price volatility is a natural mechanism for finding the equilibrium price of an asset, especially those that do not trade on a regular basis. Price volatility implies the presence of willing buyers and sellers – by definition, in this scenario, liquidity exists. While it might be unnerving, price volatility by itself is not a sign of a liquidity crisis.
A liquidity crisis occurs when there are no willing buyers (typical) or sellers (less typical) at any price across an asset or sector of the market. The crisis is likely to be preceded by a major change in economic or market fundamentals such as a sudden increase in interest rates or default levels, or the unexpected entry of a large forced seller in the market. In such crises, transactions grind to a near halt and valuations become more challenging to assess.

In the U.S. capital markets, liquidity crises have been rare, short-lived events. The crisis of 2008 was the most recent example, sparked by credit concerns in the subprime lending arena. Credit-sensitive sectors like high-yield and floating-rate loans were hit particularly hard. Nevertheless, with the aid of some emergency action, buy-side investors did step in, and within a year from the trough in prices, both markets regained all lost ground. Market participants understood that elevated liquidity costs and higher market volatility created unique buying opportunities for assets whose intrinsic values were well above their current market prices.

The upside potential of staying the course

No one can rule out another liquidity crisis, sparked by events we are familiar with (like unexpected changes in interest rates or credit quality) or some other unknown "black swan" catalyst. In past sell-offs, investors who were willing to stay the course and be providers of liquidity often have been rewarded as markets have healed and economies recovered. At the same time, fluctuating liquidity costs and bond prices are part of normally functioning markets. Investors who understand these dynamics may be well-positioned to benefit over the medium-to-longer term.

About Risk

An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments. As interest rates rise, the value of certain income investments is likely to decline. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Investments involving higher risk do not necessarily mean higher return potential. Diversification cannot ensure a profit or eliminate the risk of loss.

About Eaton Vance

Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company's long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today's most discerning investors. For more information, visit eatonvance.com.

Important Information and Disclosure

This material is presented for informational and illustrative purposes only as the views and opinions of Eaton Vance as of the date hereof. It should not be construed as investment advice, a recommendation to purchase or sell specific securities, or to adopt any particular investment strategy. This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and Eaton Vance has not sought to independently verify information taken from public and third-party sources. Any current investment views and opinions/analyses expressed constitute judgments as of the date of this material and are subject to change at any time without notice. Different views may be expressed based on different investment styles, objectives, opinions or philosophies. This material may contain statements that are not historical facts, referred to as forward-looking statements. Future results may differ significantly from those stated in forward-looking statements, depending on factors such as changes in securities or financial markets or general economic conditions. Actual portfolio holdings will vary for each client.

Investing entails risks and there can be no assurance that Eaton Vance, or its affiliates, will achieve profits or avoid incurring losses. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

SOURCE Eaton Vance Corp.