Three Ways to Manage Fixed-Income Liquidity Risk
Liquidity risk grabbed headlines this summer on the heels of several high-profile fund implosions. The hunt is now on to find ways to manage market liquidity risk and to protect portfolios against liquidity crunches.
Most investors blame stricter banking regulations for the relative liquidity squeeze since the global financial crisis. Before 2008, banks held vast inventories of bonds and traded them regularly, making a profit for themselves and making a market for other investors. This kept price fluctuations in check and was especially valuable in times of stress when investors could count on the banks to be a willing buyer when everyone else wanted to sell.
Post-crisis rules designed to make banks safer also discouraged risk-taking. As a result, banks beat a hasty retreat from the bond-trading business. They simply aren’t big buyers and sellers of bonds anymore and no longer provide ample liquidity to the markets. As a result, bonds are vulnerable to wider and more violent price swings, and investors may have to take big losses if they need to sell assets in a hurry. In other words, regulations have effectively transferred liquidity risk from banks to bondholders.
There are also less obvious causes that have the potential to worsen any liquidity crunch. Low government bond yields have forced yield-hungry small investors to crowd into the same trades. Another driver is caution by large institutional investors, who are less willing to ride out short-term market volatility. So, while regulatory changes have reduced the supply of liquidity, these trends have drastically increased the potential demand for it.
With volatility in fixed-income markets rising, investors can’t afford to take liquidity risk lightly. We believe investors can help protect their portfolios by ensuring that their bond managers adhere to three essential practices:
1) Establish a rigorous governance framework.
The first safeguard against risk is better governance. For liquidity risk, that means portfolio managers must constantly monitor security prices and allocations to different security types. Prices that are out of line with comparable securities, or “stale” prices that stay static for long periods, can be telltale signs of risks, including liquidity risk.
An effective governance process should feature daily internal price variance checks and reviews of exception reports. On a less frequent basis—say, every five days—those price reviews should be cross-checked with external vendors. And monthly, the governance team should analyze and discuss the pricing and liquidity data with the portfolio-management team. As part of these reviews, managers should evaluate portfolio liquidity against stress tests using different scenarios.