Today’s financial markets are fixated on liquidity. This is a natural consequence of a belief in the axioms of finance and modern portfolio theory, because in the artificial world of MPT, liquidity is directly related to risk.
If you define risk as the tendency of an investment to vary from its smoothed monthly return, then a lack of market liquidity that causes such variations is a bad thing, since it gives you a higher volatility reading. As a fund manager you have to avoid this, since performance geeks think such variations mean the manager is putting investors’ money ‘at risk’ in some meaningful way, and you also have to stick a higher risk number on your KIID.
Regulators – also believers in finance theory – think that a greater ability to buy and sell reduces investors’ risks regardless of the quality of the investments.
The facts tell the opposite story, which is that liquidity simply follows activity. At the peak of the tulip bubble in Amsterdam in the seventeenth century you could buy or sell quantities of tulips worth several merchant ships in a morning. At the peak of the dotcom bubble in 2000 you could readily buy or sell millions of pounds worth of shares in soon-to-be-worthless start-ups with no profits or assets. Such liquidity told you nothing about the level of risk involved.
Now consider liquidity in relation to high-yield bonds. These are securities that are not traded on a regulated exchange. The market-makers are banks which since 2007 have withdrawn between 50 per cent and 80 per cent of the capital they used to apply to holding stock. In 2008, bid-offer spreads widened to 15 per cent or more; many bonds were untradeable for weeks. It is a fundamentally illiquid market.
Historically, this didn’t matter. Those who bought high-yield bonds before 2000 were institutional investors buy-and-holding as sweeteners to a diversified bond portfolio, or hedge fund gamblers prepared to take serious losses if they got market direction or their credit analysis wrong.
Only one of these strategies remains viable: buy and hold. The lack of market-making capacity means the market is liable to be a one-way street. It is so now, with most new issues simply refinancing part of the existing stock of bonds, and a shortage of supply making the uptrend look smooth and liquidity tolerable. Everyone believes the prices quoted by banks, because almost nobody is trying to sell. What if? The FSA has asked the question but this elephant is just too big for them so they have put their pea-shooters away.
The surest sign of the imminent end of a trend is when it spawns new categories of financial instrument (think triple-A MBS). Today we have high-yield bond exchange traded funds and futures on questionable indices being created simply to allow fund managers to get invested without having to wait to buy individual bonds. But no derivative can be more liquid than its underlying securities. If the derivative appears to be more liquid – high-yield bond ETFs look more tradeable than their constituents – smoke and mirrors are at work. All they can do is briefly make the swamp look like solid tarmac.
As with land, art, wine and timber, high-yield bonds are illiquid investments that should be confined to closed-end fund portfolios. Or open-end investors should be warned up front that they may have to wait months for their money back. Or it could get very messy.
Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS Report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning