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Why You Should Consider Liquidity Risk in High Yield and Fixed Income Investments

By Art DeGaetano
September 08, 2016
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BRAMSHILL BLOG:  From the Desk of Art DeGaetano.  

Investors are reaching for yield. What risks are they willing to trade for their desired outcomes? Given our mandate at Bramshill Investments, to provide absolute return solutions in fixed income and income producing assets, clients and prospects often ask us about risks in fixed income. From our conversations with advisors lately, we have been thinking more about liquidity risk. Advisors have shared with us their challenges in building asset allocation models in fixed income – sourcing yield while managing interest rate and credit risk, but we wonder what thought is being given to liquidity risk.

Mutual fund investors watched in shock as Third Avenue found a loophole last year to suspend redemptions of a $788 million dollar credit mutual fund and essentially turn a daily liquid vehicle into a vehicle with a “lock-up.” The news story faded away, but the reality for those advisors and clients who were subject to this redemption freeze certainly didn’t. Did anyone see this article in July? Apparently, Third Avenue’s lock-up sparked some similar moves by overseas brethren running commercial real estate funds. It appears liquidity risk crosses geographic borders and asset class sectors with ease.

There are many components to discuss in an analysis of liquidity risk which we at Bramshill will continue to discuss in blogs and white papers, but let’s start with a few market insights that may help advisors considering client portfolio risk:

In our opinion, liquidity has never been too much of a concern in the investment process of many fixed income managers. In today's world, and going forward, we believe liquidity has to be a significant part of your investment process.

Central bank policy around the world has created a large amount of dollars with quantitative easing and is forcing investors out of safe assets into riskier assets such as high yield, equities, private equity, structured products, venture capital, etc.  When all of these markets are rallying and everyone is making money there's a great sense of liquidity. When things turn south, I think you will see a very large lack of liquidity and heightened volatility.

Let's just take the high yield market for example.  In the past three years, approximately 1/3 of the bond traders on the street have been fired, the dealer community has cut its capital commitment by over 60%, and the amount of issuance has doubled in bond deals. So from three years ago to today, I would say that the landscape is a potential disaster if the markets were to turn south or we hit a recession

For advisors, our advice would be:

  • Know what you own. What liquidity risk is embedded in the underlying securities of your mutual fund or separate account?
  • Ask questions. Does your manager include liquidity risk considerations in their process? Do they conduct liquidity risk / stress tests on their positions and portfolio?

For us at Bramshill, we try to avoid illiquid investments and continuously analyze liquidity both on an individual position level and on the entire level of the entire portfolio.  In the current environment, when momentum is dragging investors into the market and prices are moving on that basis more so than on value, the chances of a liquidity risk issue are even more exaggerated. As a result, a little more defense and cash-like securities in our opinion is prudent.

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Art DeGaetano is the Founder and CIO at Bramshill Investments.  Click here to view his bio and other team members of Bramshill Investments.