Detlef Glow (pictured), head of EMEA Research at Lipper analyses liquidity risks in high-yield bonds.
As a professional market observer I know there is currently a lot of discussion about the liquidity in high-yield bonds. Most of this discussion questions the liquidity of high-yield exchange-traded funds (ETFs), since these products have become increasingly popular among investors globally.
From my point of view this discussion does not reach far enough, since not only ETFs invest in high-yield bonds; there are also a number of actively managed funds, varying from specialized bond funds to multi-asset funds, that invest in high-yield bonds. Further, in the discussion of possible liquidity issues other market segments such as micro-cap stocks or exotic bonds should not be neglected, since these segments may face the same issues. But is there really a lack of liquidity?
What is liquidity?
The liquidity of a security on an exchange is the turnover in the security–the sum of all transactions, i.e., the number of traded shares multiplied by the price. By calculating the average daily liquidity of a security a portfolio manager can evaluate how long it would take for his fund to buy or sell a position in a given security during normal market conditions. However, this ratio doesn’t tell the fund manager how many shares he would be able to sell during tough market conditions.
Generally speaking, ETFs do not take liquidity into account, since they try to replicate the return of an index as much as possible. Many ETFs follow a full-replication approach, meaning the ETFs are buying all the constituents of an index at the same weighting in the portfolio as in the index. If an index is very broad, such as the MSCI World Index, or if there are constituents in the index that can’t be bought easily, the fund manager uses sampling methodology to achieve his investment objective. Sampling means the portfolio manager optimizes his portfolio with regard to the number and names of constituents needed to generate a return profile that is similar to that of the index. An ETF may also remove all securities that do not have enough liquidity to enable an efficient portfolio management process.
As long as everything is fine with the issuer, the liquidity of a security is a result of supply and demand, and the price of a security brings buyers and sellers together. This means that even though it seems there is no liquidity in a security at a given price, it does not mean there is no liquidity at all. Investors may be willing to sell the security at a higher price (increasing markets), or they may want to buy at a lower price (decreasing markets).
I am not saying there is no risk coming from the liquidity in smaller or specialized market segments, but this risk is reflected in falling prices more than in the fact that one isn’t able to sell the security. Again, liquidity is often a question of the price of the security–a lesson that a number of investors learned when the tech bubble burst back in March 2000.
Investors should always take the liquidity of a given market segment into account, since they need sufficient liquidity during normal and tough market conditions to enter or exit their positions. Though this is normally not an issue in a healthy market environment, it might become a challenge during tough markets. To protect an investor from a bad surprise, a stress test might be an appropriate way to find out how much liquidity is available in tough market conditions. Since tough market conditions might lead to a massive price decrease with a number of investors wanting to exit the market, there may not be sufficient liquidity within a market segment or security at a given price level.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.