When it comes to liquidity, where should investors focus?
Editor’s note: This post was originally published on the U.S. Russell Investments blog on 27 March 2020.
As equity markets fell at record rates in March, rebalancing fixed income to equity is all the rage. However, fixed income liquidity has thrown a wrench into rebalancing plans and now investors must be tactical with implementation. Buying declining equities is easy. Selling fixed income, well…that’s complicated.
It’s hard to generalise liquidity for fixed income. Treasuries are always liquid, but high-yield and structured products may not be. Institutional investors should be thoughtful in the selection of portfolios to liquidate.
A well-planned liquidation strategy is critical. Here are four categories we believe are worth considering right now:
- Commingled products – For investors searching for liquidity, we believe the first category they should focus on is commingled products. Many of the fixed income funds don’t charge institutional investors for cash subscriptions or redemptions. As this is, in essence, a kind of free ride for transaction costs, we believe that’s where investors should turn first, as these fixed income funds will provide cash ASAP. If investors can take money in and out at no cost, this can make these funds very helpful liquidity tools.
- Treasury mandates or treasury portions of core/aggregate mandates – Treasuries are always liquid. And in theory, it doesn’t actually matter if bid/offer spreads are wide if you are selling. U.S. fixed income portfolios are marked and valued at the bid side of the market. Any trader worth their salt can get the bid, so in theory the spread costs to sell fixed income are zero, or close to it. There may be a small brokerage charge, but this cost is minimal. Now, if an institutional investor is buying Treasuries, that is a totally different story. Upon purchase, investors pay the full bid/offer spread. But that’s not what we are talking about today. Today is all about selling fixed income, and we believe selling treasuries at the bid will have almost no performance impact on your fixed income portfolio.
- AAA-rated and AA-rated corporate bonds – These bonds are normally liquid, but in a market like we are facing today, liquidity is issue-specific. Two bonds of similar characteristics can trade with very different option-adjusted spreads (OAS) based on issue-specific risks. And, as with treasuries, corporate bonds are priced - or valued - at the bid side of the market, so in theory once again there should be no spread cost to sell corporate bonds. However, the value - or price - of the bond may not represent what the bond is worth. In fixed income, there is value (marked-to-market modeled price) and there is worth (what some other person will pay you for it), and many times they do not equal. Particularly, in times of risk off, value is greater than worth, and, in many cases, it is greater to a significant degree. This is where the transaction costs start to become alarming - when the worth is dramatically lower than value. The only way for an investor to truly know that is when they take the asset to the market and get quotes from market participants.
- MBS/CMBS/ABS – Mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), asset-backed securities (ABS) and structures products are also issue specific. Even MBS can vary from issue to issue, based on their specific characteristics, but, as of 27 March, MBS was trading slightly better than AAA-rated corporate bonds. CMBS/ABS is a different story, as there is not a lot trading in these sectors right now.
The bottom line
We are advising our clients broadly to maintain their rebalancing policies. You have a policy because you do not know exactly what will happen at any given moment in the markets. Now is a time of great uncertainty the best plan is to stick with the plan. Having said this, selling corporate bonds in this market is significantly increasing transaction costs so a more nuanced strategy may be appropriate for more illiquid parts of the market. This is where our transition management team is currently looking to help our clients find the right sets of assets to liquidate and minimise the value-is-greater-than-worth cost.
Identifying the right assets for liquidation can be challenging. Russell Investments Implementation Services experts can help identify assets in portfolios that fit the profile for liquidation and preserve total-portfolio value.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.