Income Investor Perspectives

Unlike with water flowing through plumbing, bond market liquidity is very difficult to measure.

Most traders and portfolio managers would agree that liquidity is influenced by many factors, and can change quickly. (Even the definition of liquidity is open to debate. Here, I define it simply as the ability to easily convert an investment into cash. Some participants add the qualifier that a security is liquid when it can be easily traded without dramatically affecting the prevailing market quotes. I omit that from my definition, since in the bond market, many securities are quoted only when a trade is contemplated.)

Planning for liquidity is a crucially important component of portfolio management, particularly since accepting some degree of illiquidity in exchange for higher yield is a common tactic. (As with other investment risk factors, liquidity risk should be priced into the yield demanded by an investor considering a bond investment–the greater the risks accepted, the higher the yield that should be expected. Unfortunately, there are many examples of yield hungry investors having given into the temptation of stretching for higher relative yields, not realizing until much later that they had unwittingly accepted greater liquidity risk.)

An incomplete and distorted view of bond market liquidity, however, is depicted in “The New Bond Market: Some Funds Are Not as Liquid as They Appear,” The Wall Street Journal (September 22, 2015). (Link for subscribers.)

Some of the largest U.S. bond mutual funds have invested 15% or more of their money in rarely traded securities, a practice that runs counter to long-held Securities and Exchange Commission views on the funds, an analysis by The Wall Street Journal shows.

The finding is one indicator of inconsistency in how fund managers calculate the liquidity in their portfolios, a hot-button issue for investors and regulators. By the Journal’s measure, 10 of the 18 largest funds that invest meaningfully in corporate debt have significant holdings of seldom traded bonds.

According to The Federal Reserve Flow of Funds report (September 18, 2015, Table L.208), there are $11.8 trillion of Corporate and Foreign Bonds outstanding in the United States. According to data from SIFMA, in August of this year, Average Daily Trading Volume of U.S. Corporate Bonds was running at $18.6 billion–or approximately 0.2% of the total outstanding. So does that mean that 95% or more of the corporate bond market is illiquid because matching CUSIPs did not trade that month? Hardly.

To be sure, some bonds don’t trade because fund managers value them highly and could easily be sold if need be. Loomis Sayles sold a roughly $96 million Ford Motor Co. bond investment within five days, while the Journal’s analysis indicated it would take 65 days.

The Journal analysis concluded that a single Ford bond would take 65 days to transact? For one of the largest and most widely held bond issuers in the market? Clearly, the Loomis Sayles portfolio manager and trading desk did not rely on a similar analysis.

This is not to suggest that examining liquidity is not a worthwhile topic–it is a very important topic, especially now with the nature of the bond markets having changed and continuing to evolve quickly. Bond investors are able to compare many characteristics of their investments–yield, duration, credit risk, etc., but liquidity defies easy quantification. Investors (and journalists) and reminded that bonds are not stocks, and trying to apply a stock market perspective to examine the bond market can lead to incomplete (or erroneous) conclusions.

For those interested in digging deep into the topic of bond market liquidity, there have been some excellent articles published by a number of firms, of particular note is a July report from BlackRock, “Addressing Market Liquidity.”

What do you think?