Fixed Income Blog

Three Ways to Manage Liquidity Risk in Bond Markets

23 August 2019

4 min read

Liquidity risk has grabbed headlines recently after several high-profile funds imploded. The hunt is on to find ways to manage liquidity risk and protect portfolios against further setbacks—but not all investors will be up to the task.

The liquidity squeeze has been brewing since the global financial crisis, as tighter regulation has forced banks to strengthen their balance sheets and slim down their exposure to businesses such as making markets in securities. The result? Banks’ primary dealing businesses no longer provide ample liquidity to markets, so liquidity risk has transferred from the banks to stock- and bondholders. We think investors need to respond by ensuring they use rigorous governance, cutting-edge technology and risk-aware portfolio construction.

#1: Rigorous Governance Framework

The first safeguard against risk is better governance. For liquidity risk, that means portfolio managers must constantly monitor security prices and allocations to different security types. Prices that are out of line with comparable securities, or “stale” prices that stay static for long periods, can be telltale signs of risks, including liquidity risk.

On a daily basis, an effective governance process should feature internal price variance checks and reviews of exception reports. On a less frequent basis (say, every five days), those price reviews should be cross-checked with external vendors. And on a regular monthly basis, the governance team should analyze and discuss the pricing and liquidity data with the portfolio-management team. As part of these reviews, portfolio liquidity should be evaluated against stress tests using different scenarios.

Liquidity reviews are most effective when viewed through different lenses—for instance, comparing internal assessments with third-party specialists that have proprietary methodologies. These comparisons offer a further, objective assessment of the liquidity profile of a portfolio’s fixed income assets.

#2: Technological Innovation

Forward-looking bond managers have already transformed research and trading, upgrading from highly manual approaches to digitized, automated processes. Research findings can now be automatically accessed and filtered, and orders to buy or sell that might have taken many hours to prepare can be compiled using digital assistants—chatbots based on computer algorithms. In fast-moving bond markets that are fragmented across many small puddles of liquidity, this technological leap is already creating a significant edge. That edge will become even more important if and when liquidity is further stressed.

#3: Portfolio Construction

In current markets, avoiding concentration risks that can lead to liquidity traps is paramount. In less-liquid parts of the bond markets, trading costs can be high and may rise steeply for larger trades. By holding a more widely diversified basket of securities, investors can trade more flexibly and cheaply. A risk-aware portfolio construction process should feature a rigorous approach to controlling cost and risk through minimizing individual exposures and diversifying across multiple issuers. Good management control systems should provide at-a-glance access to this information (Display).

Risk Control Through Diversification

Portfolio Exposures at a Glance

As of June 30, 2019
Data retrieved from AB’s internal system RAP using issuer ticker. Different ratings on bonds from the same issuer were bucketed according to primary exposure by rating.
Source: AllianceBernstein (AB)

Sophisticated portfolio construction techniques aim to reduce both risk and cost. For example:

Trading in derivatives such as credit default swaps may be a cheaper and more liquid approach to implementing an investment idea than trading the underlying security.
Bonds with optically attractive yields may be less liquid. It is important to evaluate whether the yield on a given security adequately compensates for the liquidity risk.
Diversification can help achieve a portfolio’s overall risk and return objectives, for instance, by holding cash and/or highly liquid government bonds for flexibility.

Investors with limited risk appetites may benefit from dynamically managed, risk-aware portfolio-management approaches. For instance, strategies that combine the stability of government bonds with the return-generating properties of corporate credit may capture attractive yields while reducing liquidity risks. Balancing exposures to different economies and industries with varying risk and liquidity characteristics helps create a more efficient overall risk/reward profile. And while government bonds may offer little income, they can enhance the liquidity of the overall strategy.

By contrast, we believe risk-conscious investors should approach bond ETFs with care. In fact, the UK’s Financial Conduct Authority recently announced an investigation into the resilience of ETFs and their ability to offer the expected level of liquidity in times of market stress—following representations from AB and other leading asset managers.

Bond markets are too vast and diverse to replicate precisely. So ETFs typically use sampling methodologies to create representative exposure to their chosen underlying markets. This may make them vulnerable if large redemptions trigger sell orders where there is no liquidity—particularly in higher-risk markets such as high-yield or emerging-market corporates. Frequent rebalancing can also hit ETFs’ returns, especially during periods when trading costs are high.

The Way Forward

Implementing and refining the three approaches described above takes time, money and deep resources. Not every asset manager is up to the task. We believe investors should take liquidity risk very seriously and ensure they have all the resources necessary to manage it.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.