How to manage liquidity in credit portfolios
History has shown us that fixed income markets may be severely affected by liquidity events. This can have the impact of causing extreme volatility in short periods of time, creating challenges around risk management and drawdown control.
Since the Financial Crisis, as market liquidity has fallen, the ability to measure liquidity has become even more challenging. This means that managing credit risk within a portfolio context has become much harder. In this environment, investment managers are having to draw on a greater breadth of liquidity indicators to navigate through the market cycle, and are taking a more focused approach on their bottom-up research and expertise.
Although sovereign markets are regarded as the most ‘liquid’ securities within fixed income markets, history has shown us that they can be severely affected by liquidity events. This can have the impact of causing extreme volatility in short periods of time, creating challenges for investment managers around risk management and drawdown control.
The ‘Flash Crash’ in October 2014 saw a big range day for US treasuries where they rallied 30 basis points in just two hours of trading, then quickly fell to similar levels to where they started. The catalyst for the volatility was the release of the US retail sales report which was weaker than consensus, but not hugely out of range of expectations. Interestingly, the volatility was concentrated within the treasury market, it was extremely high, and occurred with very large volumes (approximately four times that of a normal day).
What caused the ‘Flash Crash’?
Looking into the causes of the ‘Flash Crash’, it is noted that there was a shortage of offers in the market, rather than a shortage of bids. So, the problem wasn’t selling bonds, it was buying them. At no stage was the market so dislocated that there wasn’t a two-way market. There was always a bid and an offer, even if it wasn’t the offer investors wanted.
The US Joint Staff report into the ‘Flash Crash’, which was released in July, looked into why this event occurred. Some of the reasons may be related to changes in markets, and some were due to regulatory changes that had taken place. This includes the withdrawal of market-makers who are the traditional providers of liquidity.
The risk of a dislocating market event goes up materially the more significant a small number of players has become. If we look at the composition of market-makers in Australia, we can see from the chart below the percentage of turnover in Australian Government bonds and Australian dollar interest rate swaps is accounted for by the top eight banks in the market.
Since 2010, that proportion has been steadily climbing, particularly for physical government bonds. A number of offshore banks have withdrawn from the local market or become increasingly discriminating about exactly which areas they will be active in. Further, while turnover has been increasing, it hasn’t kept pace with market size – for the past three years dollar turnover in physical market securities has been relatively stable.
Market turnover from top eight banks (%)
How to manage liquidity risk?
The ability to measure liquidity risk starts with a clear understanding of the structural components of your core portfolio. That is, what are your objectives going forward, and what are your liquidity needs likely to be?
Throughout 2015, there have been many approaches trialled by investment managers around the globe designed to manage liquidity risk in credit portfolios. Some of these have been traditional approaches such as holding higher cash levels, sell spreads, while others have been less conventional in their application.
At AMP Capital we have tested the risk and return of a variety of concept portfolios which combine varying degrees of derivative liquid overlays among core portfolios. The results of this analysis indicate that this approach may enhance the potential to actively manage return outcomes – and have relatively small impacts on total volatility for credit portfolios. We believe that approaches such as these are a good alternative that SMSF investors may wish to think about to manage liquidity risk in credit portfolios.
What does this mean for SMSF investors?
The concentration of market-makers in Australia leaves investors in this market vulnerable to ‘liquid’ events in the future. At AMP Capital, we are constantly tracking data within the market, and factoring miscorrelated moves into our scenario analysis. And while this environment certainly presents challenges for investors going forward, it is also important to note that in the face of unchanged fundamentals, volatility events can present opportunities for investors with a sound process that can cut through the noise.
For access to AMP Capital’s capabilities in fixed income, see the Corporate Bond Fund.
About the author
David Carruthers is the Head of Credit and Core at AMP Capital where he leads the Global Fixed Income team’s credit and core bond fund capabilities and is responsible for macro credit strategy.