Briefing: ‘Ill’-liquidity?

• Market participants have varying perspectives on liquidity
• Policy changes can reverse liquidity trends
• Illiquid assets can give long-term investors more control

The changing financial services landscape raises doubts about the belief that publicly traded investments are more liquid than private ones. Investors could overestimate the potential liquidity of traditional fixed-income products and should consider private investments rather than missing out on return potential.

Whenever investors discuss how to incorporate new products like private debt in their strategies, liquidity always comes up. Many private instruments are characterised as illiquid – the possibilities to trade on a secondary market are limited. As compensation, investors expect a higher return than from assets that carry similar risk but can be traded.

Since the financial crisis, many traditional sources of liquidity have dwindled or disappeared altogether. For example, legislation aimed at improving solvency has forced investment banks to reduce their inventory levels substantially. At the same time, less conventional liquidity sources have appeared, such as alternative lenders. These new financiers operate in a different regulatory framework than banks.

We talked to market participants who play different roles in the capital markets. They were able to give us a broad view of what liquidity means and how they take it into account in their investment decisions. 

Liquidity: Why is it relevant?

How investors interact with the market determines how they look at liquidity. For traders, liquidity means being able to execute trades of the desired size without excessive impact on the market or price. Rutger Olthof, senior trader at NN Investment Partners, notes that the effect of the trade size on the spread is a good indication of market depth, an important component of liquidity. 

A good working definition of a liquid market is one where a billion-euro bond trade does not affect the price, according to Henk Rozendaal, global head of interest rate derivatives trading and eurobond trading at Rabobank. Another aspect of liquidity is the speed at which assets can be sold. Speed differs astronomically between asset classes, ranging from microseconds for blue chip equities to months for real estate. When dealing with a trading book, the length of time an asset sits in inventory – its ‘staleness’ – is a liquidity indicator, Rozendaal says.

index returns

From a risk angle, a look at the role of agents in the financial markets and their interactions provides insight into liquidity. By accounting for which investors hold which assets, one can observe by simulation how liquidity stress in one pocket can spread stress in other market segments, according to Arjen Pasma, managing director risk and compliance at PGGM. 

In contrast to bid-ask spreads or staleness, the network model cannot be used for predictions or for trading, according to Coen Weerkamp, risk management and financial policy manager at PFZW. It adds a perspective and is helpful in answering questions such as: what are possible pockets of liquidity stress that we have not seen before?

Euro fixed-income markets are less liquid than they used to be. An important reason is the European Cantral Bank’s (ECB) intervention as a buyer, which has created one-sided liquidity. At times, this has created circumstances in which one could sell a virtually infinite amount in bonds and place all the proceeds with the central banks while buying became more difficult. This one-sided liquidity masks underlying liquidity, which might cease once the ECB stops buying. 

The difference between perceived and actual liquidity plays a key role when it comes to funds that provide liquidity to illiquid investments, such as leveraged loans or real estate. For instance, UK commercial real estate funds were forced to lock up after the Brexit referendum. Once the buying market ceased, selling the properties and redeeming investors took months. The liquidity of the underlying investment can have unexpected implications at the fund level, which is not always as liquid as it appears.

Fixed-income under stress?

A common post-crisis theme for banks was investors’ need for high-quality liquid assets. Central banks created one-sided liquidity on unprecedented scale, draining liquidity from the other side. Simultaneously, regulation made it expensive for banks to supply liquidity to the market.

All this could lead one to believe market liquidity is poor. But, while larger trades are more costly, smaller tickets never really have been a problem, according to Olthof. He says inventories may be smaller, but the willingness to trade is not.

Furthermore, pockets of liquidity still exist. “It still amazes me that bonds with really long maturities are easy to buy,” says Tjeerd van Cappelle, head of third party liability-drive investment at NN Investment Partners. “It is a small universe, but there is still issuance.”

Keep in mind that market liquidity is sensitive to central bank policy. Rapidly rising rates could quickly reverse one-sided liquidity. Markets would become illiquid, and investors would be running for a small door. 

Liquidity plays a larger role in the performance of bond markets nowadays than before the crisis. Investors can gain understanding of the liquidity of their portfolios by incorporating indicators into their investment process. 

Investing in private markets

Long-term investors also need to consider funding liquidity – the speed at which assets are transferred into cash to fulfil obligations.

The long-term investment horizon means pension funds have more liquidity than needed, even under stress tests, and can therefore invest in asset classes that take years to liquidate.  

Michael Kaal, executive board member at Stichting Algemeen Pensioenfonds Unilever Nederland, asks why, as a long-term investor at a closed pension fund, he needs portfolio liquidity. The fund is looking more into the less-liquid fixed-income sphere. 

Long-term investors agree that private markets offer opportunities. The reduced difference in liquidity with public markets since the crisis makes the case stronger than ever.

A practical tip for investors who wants to take steps in private markets would be to educate stakeholders. Highlight transparency and control. By investing in private loans for instance, investors have better opportunities to control assets. “Go back to basics. Pay attention to the misperception of risks,” says Kaal. “These are interesting products with much more control than liquid fixed-income.”

Gabriella Kindert is head of alternative credit at NN Investment Partners and Richard Sanders is a strategic advice specialist at the same firm. Their views do not necessarily reflect those of their employer

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