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Liquidity... what liquidity
By Henry Adams on 2020-03-27
The recent turmoil has reverberated across many pockets of financial markets and we have already witnessed and engaged in a great deal of discussion around the scale of discounts being offered across the mutual fund space.
Pressure to meet redemptions, as well as an illiquid cash market for underlying assets that need to be sold to meet the demands of exiting investors has caused huge challenges for fund managers that offer the promise of daily liquidity to their clients, whilst investing in longer dated and less liquid assets. In the US, the Fed has now stepped in to include some of these products in their “limitless” QE program. Is it only a matter of time before equity indices are included as rate cuts below zero are not an attractive option?
We saw it first in property funds in the UK several months ago…yes…prior to any indication of what was to follow. However, much like the virus, this has sadly spread rapidly to many more places, leading to the need for swift action and in size. The dynamics now at play in the US are also rather concerning, with funds shuttering along with fire sales and auctions of seized assets.
ETFs in the high yield space were unsurprisingly one of the first to be affected, but contagion spread rapidly to the investment grade universe. How to handle such requests for cash in a portfolio constructed of rather illiquid (arguably also in the good times) bonds became a challenge. The regulation that followed the 2008 crisis to safeguard the economy and reduce the potential of bank insolvencies caused dealers in fixed income markets to dramatically reduce their market-making functions, in particular in asset classes where the regulatory cost of performing this function versus the overall return for that business ceased to make economic sense. As a result, bank balance sheets in these sectors shrunk significantly.
Discounted pricing is the natural mechanism to encourage new buyers to take units at levels below the marked NAV (net asset value) in order to facilitate redemptions. As one might expect with real estate, especially in the commercial space (with everything closed and an inability to generate revenue from traditional physical premises) this portion of the market is taking a sizable hit. What this in turn means of course is that underlying debt instruments are seeing stresses in the mortgages backing them. With a plethora of highly-leveraged products on the market, when funding dries up these are the areas of the market most exposed to such liquidity shortfalls. The size of this market is estimated to be $16T in the US alone, with a large swathe of paper not carrying any Federal guarantee and thus highly susceptible to external shocks.
The next market to show visible signs of stress was the general corporate bond ETF space. Here, investors buy exposure to the investment grade corporate debt market with the promise of intraday liquidity at prices close to the Net Asset Value of fund, with liquidity being provided by market makers who can make arbitrage profits if the value of the underlying assets (which they can buy and then sell to hedge themselves) exceeds the NAV at which investors are willing to redeem from the funds.
ETFs were a brilliant idea, a genuine market innovation which has catapulted the industry from nothing to $4T+ in two and a half decades of breakneck growth. The problem is that ETFs were created for highly liquid markets (they started in the S&P 500) where the market makers could guarantee arbitrage profits, knowing that they could trade underlying equities in almost unlimited size with tight pricing. If you contrast this with the current, rather illiquid corporate bond market, it is easy to see how the ETF toolkit might falter – if a market maker has limited visibility as to where they can sell the underlying assets, they are going to demand a much bigger discount to NAV than exiting investors might expect.
When everything is going well, these issues are hidden by the fact that inflows into the funds greatly exceed outflows so, without any selling pressure, market makers can easily perform their function against the backdrop of a bull market in bonds where prices have generally only gone in one direction. Unfortunately, the world that we find ourselves in today is rather different – with fixed income markets experiencing massive illiquidity (driven by all sorts of pressures that we have written about previously), market makers have great difficulty in pricing underlying bonds and hence needing to command significant discounts to buy ETF shares in order to protect their own positions.
The net result – we have seen fixed income ETFs trading discounts to NAV that are 20 standard deviations away from normal market conditions. What that means for exiting investors is that they need to take very significant losses in order to avail themselves of liquidity. One representative example is that the Vanguard Total Bond ETF, one of the largest fixed income ETFs in the world at $55b AUM, traded at as much as a 6% discount last week. That means a realised 6% loss for any investors exiting a fund that they probably assumed they could always trade out of at NAV.
There are also many traditional mutual funds that offer exposure to the same fixed income assets as these ETFs. For brevity, we will save an analysis of these for another post but, suffice to say that ETFs have a much more efficient price discovery mechanism than their mutual fund cousins, so we would be wary of current NAV marks in those vehicles.
Whilst for most of our client universe of “cash” investors these products seem rather far from home and their issues might reasonably be expected to affect only professional investors, little-talked about effects of contagion and correlation are already pervading the “safest” corners of the market. If real-estate funds were the canary and ETFs the Overmen, the coal mine is populated by a huge number of corporate investors in products that have traditionally been perceived as “risk-free”.
NAVs in prime money market funds (MMFs) have been far from immune to the stresses currently being experienced. The extreme nature of market movements has led to several of these funds in the US needing assistance from their sponsors and the Fed to meet liquidity needs (let alone price stability). Redemptions have come hard and fast – hundreds of billions and counting globally.
As these dislocations reverberate through the commercial paper market, the Fed has been required to step in (as it did in 2008) to provide liquidity to ensure an orderly and timely redemption process. Sponsors have also purchased billions of dollars of assets from certain funds for the same purpose. Not all providers will have that (expensive) luxury, in particular given the strain already on balance sheets during these extraordinary times.
Prime MMFs in the US have already been put on “watch – negative” by Moody’s as well as Fitch. It will be interesting to see if/what measures are taken in other jurisdictions as cracks appear in offshore fund complexes, where a coordinated response is harder to pull off. As of the time of writing, we are seeing the US dynamics being replicated in Europe, with a reduction of $93Bn month to date to $1.002Tn (as of 20 March, further sizable balances have continued to flow out over the course of this week).
Notwithstanding the unprecedented social and economic circumstances that we are living in, the scale of central bank intervention that might be necessary to prop up fixed income funds across the board is obviously not desirable in a stable, robust and resilient capital markets framework.
It is undeniable that the reforms to bank and fund regulation in the aftermath of the last crisis have delivered a financial system that is safer and better prepared for a catastrophic event like Covid-19 than it was in 2007. Whether those reforms went far enough will be debated at length when we come out the other side of this (hopefully soon); but we are certainly witnessing another stark reminder of the inherent and unavoidable problems with the assumption that daily liquidity is achievable in a portfolio whose underlying instruments are longer-dated, and only liquid…until they are not.
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