Liquidity is a vital sign of health in the financial system: too much, and the tides drag asset valuations off their moorings; too little, and prices are stranded on the riverbed. Between these extremes, however, investors would do well to consider the more subtle aspects of the current state of liquidity in credit markets – where it is scarce, where it clusters and how strategies need to adapt to these new conditions.
Since 2008, many investors have watched nervously as liquidity in the secondary credit markets seemingly drained away. In fact, liquidity has pooled in certain parts of the market, enabling healthy trading volumes in these sectors. Most market participants would be well aware of the factors contributing to this development, which include:
- Immense growth in the size of the market (particularly in the US). For example, the high-yield (HY) market expanded from $571.3bn to $2.1tn in the seven years to the end of March this year;
- Dominance of large issuers with more multi-layered capital structures;
- Dwindling dealer inventories, as banks are forced to reduce balancesheet risk in order to comply with capital-adequacy regulations; and,
- Vulnerability to redemptions by retail investors, particularly in a lowreturn environment
Rather than focus on overall market liquidity, investors should assess the differences in trading volumes among various sectors of the market, and ensure that their strategies are flexible enough to take advantage of these changes.
Why Trading Signals Speak Volumes About Liquidity
An important development affecting credit-market liquidity has been the number of alternative credit instruments coming to the fore.
In particular, the market for credit default swaps (CDS), which features single-name and index derivatives, shows the growth of alternatives to bonds.
Figure 1 shows how bonds now represent only 35% of instruments traded in the US investment-grade (IG) market, and how corporate bonds possess only a marginal majority in the US HY market of about 45%. This also shows the emergence of ETFs in the HY market, which is worth monitoring by investors.
Figure 1. Weakening bonds: trading volumes in US credit markets
Source: DTCC, SDR, Bloomberg, J.P. Morgan as at May 2017.
Note: trading volumes are averaged over the first three quarters of each year in billions of US dollars per day.
Importantly, too, the presence of asset managers in the credit derivatives market has increased in the last three years at the expense of banks. The latest data from CDX, a CDS index supplier, puts asset managers’ current share of the market at 27% compared to just 11% in 2013.
In the single-name CDS space, asset managers now own 19% of the market, more than double the 9% that they held in 2013. Likewise, asset managers have doubled their share of CDX index options to 20% in the same period (see figure 2).
Figure 2. Asset managers are steadily increasing their market share in CDX indices
Source: J.P. Morgan as at 31 December 2016. Data for 2016 is limited to the period of January to October.
However, across the entire corporate credit market, trading volumes of index and single-name CDS have declined over the three-year period. For instance, an average of $22.7bn was traded each day in the CDX IG index in the first three quarters of 2016, representing a 37% drop in activity compared to 2013. Nonetheless, the 2016 CDX trading statistics were up 5% on the 2015 results.
In the HY market, 2016 index trading volumes were down both over the 12-month and three-year comparative periods. Specifically, the CDX HY index traded an average of $6.4bn each day from the first quarter of 2016 to the third quarter. This was about 15% lower than the level recorded in 2015.
Throughout the past three years, single-name CDS have witnessed the largest percentage decrease in trading volumes. During the first three quarters of 2016, an average of $2bn in IG single-name CDS were traded each day and $0.9bn each day was traded on average in HY single-name CDS. This is down about 30% year-on-year and 60% lower than the 2013 volumes for both IG and HY single-name CDS.
But investors must put the recent decline in perspective: it follows a very high climb and despite the descent, CDS instruments still represent 65% of the US IG market.
Where Liquidity Is Pooling
Greater trading in derivatives is a significant development, but it only tells half of the liquidity story in today’s market. Rather than draining away, as the overall figures suggest, bond liquidity has clustered among the securities issued by the largest companies. As a result, many investors seek the same bonds, resulting in crowded trades (see figure 3).
Figure 3. Breakdown of the high-yield market to reflect issuers’ bonds outstanding
Source: Markit iBoxx EUR Liquid High Yield Index TRI, Goldman Sachs Global Investment Research as at 31 March 2017.
The majority of smaller HY issuers in the European market present a valuation challenge for investors. As dealer inventories shrink, liquidity is likely to shift towards the most popular issuers, which can access the debt markets more regularly because of their size. As a result, the liquidity premium in smaller names is likely to be higher. Investors would be attracted by this premium, particularly in companies with strong fundamentals. However, given that investors in these onesecurity issuers are unable to hedge or exit quickly, some of these liquidity premiums do not seem high enough. This can cause problems for funds that offer daily liquidity but invest in bonds that might not be able to honour this commitment, creating the potential for mismatched liabilities.
A lack of price continuity is closely related to this. In periods of stress, inconsistent liquidity has resulted in prices moving sharply, and this ‘gap’ risk has become normal, particularly in the HY market. CDS instruments can be used to hedge idiosyncratic gap risk in these circumstances.
Larger issuers typically have more layers in their capital structures. And in a market where liquidity is clustering around larger names, an ability to seek opportunities among the bonds, loans and CDS in these more diverse capital structures is vital for investors seeking consistently strong risk-adjusted performance. Those constrained to investing in bonds are more likely to be exposed to call risk with fewer opportunities to hedge or invest in CDS and loans that demonstrate better potential for returns.
We believe that the current state of liquidity in credit markets provides a convincing argument for investors to widen their universe beyond bonds. This would enable them to better access credit risk across capital structures while improving the liquidity of their portfolios.
Why High Cash Levels Are A Poor Alternative
Despite the depth of trading among larger issuers, liquidity concerns exist in the credit markets, with trading volumes across instrument types flashing some familiar warning signals. Total year-on-year trading volumes across all products was up during 2016, but down compared to three years ago in the IG market. In the HY market, annual trading figures were flat relative to 2015 but were higher than in 2013.
Across IG and HY funds, cash balances have remained at relatively high levels. This may be a structural shift, and we believe that managers who do not diversify by incorporating derivatives and loans alongside bonds in their strategies will have to wear the cost of cash drag on their portfolios. They incur a substantial opportunity cost, given that an ability to invest across the capital structures of the largest issuers allows investors to compare which bonds, loans and CDS offer the best relative value.
Credit derivatives can also play an integral role in new liquiditymanagement strategies, such as the ‘liquidity ladder’ approach. It comprises three rungs: operational cash, which is literally money in the bank; reserve cash, consisting of sovereign debt or other high-quality IG bonds that provide a buffer protecting day-to-day operational cash; and strategic cash, including short-dated credit instruments and CDS. As cash is extracted from the bottom rung, liquidity flows down from the one above. This approach is relatively unexplored by investors.1
Given the clustering of liquidity in markets, coupled with volatile investor flows, funds forced to hold significant cash positions are at a severe disadvantage in the context of a market in which investors worldwide are searching for yield. Furthermore, in the current lowinterest-rate environment, funds holding cash will inevitably suffer due to the opportunity cost of not being fully invested. They are also subject to extra charges from custodians, resulting in a return profile that, even in nominal terms, is significantly below zero.
Despite headlines to the contrary, liquidity has not deserted credit markets: rather, it has clustered around large issuers with global operations, which typically have more complex capital structures. At the same time, volumes of trading in credit derivatives have grown substantially, while bond trading has declined.
With liquidity pooling among the biggest names in the index, and the number of bonds that they issue in decline, it is important that credit investors widen the net. Those constrained to investing in bonds alone cannot access the opportunities presented by loans and CDS in the most liquid names in the market. They are also exposed to crowded trades as other investors are similarly drawn to the most liquid bonds.
Like investing strictly in bonds, we do not believe that holding excessive cash is a viable liquidity-management strategy. It creates cash drag, diminishing returns and incurring opportunity cost. Also, hoarding cash is not required to effectively manage liquidity, as the growth of CDS supports strategies such as liquidity laddering.
Liquidity has not disappeared: it has changed course. Has your credit strategy?
- 1 We have discussed the potential benefits of a liquidity ladder in “How to make your dough rise nicely,” published 4 October at www.hermes-investment.com/ukw/blog/press/make-dough-rise-nicely.