Crowded Trades, Liquidity Problems and Tech Solutions

24 October 2018
3 min read
Crowded Trades, Liquidity Problems and Tech Solutions
Jeff Skoglund, CFA| Chief Operating Officer—Investments
Gershon M. Distenfeld, CFA | Director—Income Strategies
James Switzer| Head—Municipal Bonds
Scott DiMaggio, CFA| Head—Fixed Income

Crowded trades have become all too common in fixed-income markets. But running with the crowd is risky, particularly when it comes to illiquid assets like bank loans that may not be easy to sell during a market downturn.

Exceptionally low interest rates have at times over the last decade pushed yield-hungry investors into a handful of sectors with a high income potential—high-yield bonds, emerging-market debt, and so on. In the case of high-yield bank loans, the attraction has been floating-rate coupons, which can help shield these assets from the losses fixed-rate bonds may suffer now that low interest rates are finally rising.

The problem is that most of these higher-yielding assets carry varying degrees of liquidity risk. Liquidity measures how easy it is to buy or sell an asset without drastically affecting its price. Highly liquid bonds such as US Treasuries or German Bunds can be bought and sold easily in rising and falling markets.

Many other types of assets don’t fit the bill. Take bank loans: trades can take weeks to settle, and loans don’t change hands often. Yet most investors own bank loans through mutual funds or exchange-traded funds, highly liquid instruments that investors can enter and exit at will.

When Does Liquidity Dry Up? When Investors Need It Most

This creates a liquidity mismatch—vehicles that promise “daily liquidity,” but invest in assets that can’t be traded on a daily basis. That concerns us, because as we’ve noted here and here, we think bank loans will be vulnerable to large drawdowns when credit conditions become less favorable.

It would be a mistake for investors to assume they’ll be able to sell assets quickly—even those that may have appeared reasonably liquid in calmer conditions—without taking big losses. As anyone who buys and sells financial securities for a living knows, liquidity is a mercurial thing. It tends to be abundant when you don’t need it and scarce when you do. With the crowding in bank loans and even some other credit markets today, we think it’s safe to say that if everyone tries to exit at once, some won’t fit through the door.

Why Manager Selection Matters

Investors can certainly choose to avoid a particular sector. We’ve repeatedly advised as much when it comes to bank loans, where we think the risk outweighs the potential long-term reward.

But it’s nearly impossible to avoid liquidity risk altogether. Limiting portfolio holdings to high-quality government bonds and liquid short-term instruments isn’t an option for most investors—at least, not if they want to maximize potential returns and a portfolio’s earning potential. Most investors will need some level of exposure to less liquid—and at times congested—sectors of the fixed-income market.

That’s why it’s so important to have a manager who recognizes the importance of managing liquidity risk and has the tools to do it effectively. That’s no easy feat today. Liquidity has grown scarcer and more fleeting since the global financial crisis. Dealer balance sheets have shrunk even as the size of the market has grown. Even relatively small events can freeze bond markets.

Plugging into the Digital Future

Thankfully, fixed-income managers who have adopted new technology are able to read markets and react far more quickly in all kinds of liquidity conditions.

Even when liquidity is normal, a bond that seems to be available can disappear moments later, and the appetite for a security can fade just as fast. Having a centralized feed of market liquidity information and a combination of machine and human intelligence to monitor that feed gives investment professionals an edge when it’s time to grab a coveted bond or unload one that no longer serves the portfolio. That ability will be especially critical during a liquidity crunch, when the first to transact often wins.

Under such scarce liquidity conditions, tech tools that can survey the entire bond market won’t serve just one purpose. These same tools will also help investment managers ensure that they’re getting the best pricing without having to spend precious hours calling multiple brokers for quotes.

And other digital machines, by integrating the data that traders, analysts and portfolio managers rely on, will help to identify new investment ideas.

The result: instead of following the crowd into a sector, managers can scoop up the hidden gems within it. It may even mean fewer crowded trades to begin with. That would be a healthy outcome for all investors.

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.


About the Authors

Jeff Skoglund is Chief Operating Officer (COO) for Investments. He is responsible for driving strategic planning, organizational effectiveness and operational excellence. Skoglund was previously COO of Fixed Income and was responsible for business strategy, innovation and technology, and talent management. Earlier in his career at AB, he was director of Credit Research and a portfolio manager for high-yield bond strategies. Prior to joining AB, Skoglund was a managing director at UBS Investment Bank, where he held numerous management positions, including global head of credit research and head of US credit desk analysts. He was an acclaimed high-yield analyst at UBS, Merrill Lynch and Credit Suisse, ranked #1 by Institutional Investor in automotive/auto parts six years in a row. Earlier in his career, Skoglund was an equity analyst and investment banker at Lehman Brothers and worked at Morgan Stanley in equity derivatives. He holds a BS in finance from Miami University, Ohio, and an MBA from the University of Michigan. Skoglund is a CFA charterholder. Location: Nashville

Gershon M. Distenfeld thrives on facing challenge, solving problems and putting people with different personalities and different viewpoints together to "make the engine run." When he joined AB in 1998 from a role as an operations analyst at Lehman Brothers, Distenfeld had long been fascinated by the high-yield market, and he led that practice at AB from 2006 to 2016 before assuming responsibility for all of credit. He has been co-head of fixed income since 2018.

In an industry that tends to focus on the short term, Distenfeld's investment philosophy takes the long view, considers a range of outcomes and focuses on the downside. This approach puts process and constant innovation at the forefront, making full use of AB's proprietary technology to mine the insights of fundamental and quantitative research.

"We're constantly reinventing ourselves," Distenfeld says. "We don't just sit still. We adapt to new information so we can find new factors that work."

Distenfeld's eye toward the long view extends to his charitable work with organizations like New Jersey NCSY. This youth organization for disaster relief partners with Habitat for Humanity and NECHAMA to repair homes and lives affected by natural disasters.

James Switzer is a Senior Vice President and Head of Municipal Bonds. He is responsible for driving our municipal bond strategy, including the firm’s innovation efforts within our municipal research, trading and portfolio construction processes, underpinned by best-in-class technology. Switzer has been instrumental in the strategic repositioning of our trading organization and the development of our industry-leading trading tools, ALFA and Abbie. Before joining AB in 2011, he was a managing director at Société Générale, where he managed the Financial Institutions Credit Trading Desk, and at BNP Paribas, where he managed the Investment Grade Trading Desk from 2000 to 2002. Switzer also formerly served as a sector portfolio manager and trader at UBS Principal Finance (from 2002 to 2005) and at Sigma Capital (from 2005 to 2008). Earlier in his career, he worked at Paine Webber and Co.; Kidder, Peabody & Co.; and Alex. Brown & Sons. Switzer holds a BA in biology from Colgate University. Location: New York

As Co-Head of Fixed Income and Director of Global Fixed Income, Scott DiMaggio oversees all of AB's Global Fixed Income, Canada Fixed Income and US Multi-Sector Fixed Income strategies, as well as their associated investment strategy, activities and portfolio-management teams. Prior to joining AB's Fixed Income portfolio-management team, he performed quantitative investment analysis, including asset-liability, asset-allocation, return attribution and risk analysis for the firm.

DiMaggio came to AB as a quantitative analyst, drawn by the firm's culture of strong mentoring and smart, collaborative people who wanted to win for their clients.

"The world of fixed income—the world I grew up in—is enormously complex," DiMaggio says. Its complexity needs an active management approach. His investment philosophy combines the lenses of fundamental and quantitative research to generate the information that can lead to risk-adjusted returns for clients. Fully leveraging AB's proprietary technology, it's a process that DiMaggio and his team refine and repeat.

"What we do is process driven and structured," DiMaggio says. "We like to be consistent."