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I n t e r e s t R a t e s a n d Yo u r P o r t f o l i o
Liquidity and Your Portfolio
Since the beginning of the global financial crisis, the term “liquidity” has been thrown around a
great deal—sometimes carelessly. That said, the concept is of crucial importance to investors of
all stripes. There are two basic forms of liquidity. The first form, “internal liquidity,” refers to a
business, municipality, or individual’s ability to borrow to meet short term obligations. The second
form, “external liquidity,” is what concerns us today. External liquidity refers to the ability to sell
an asset or investment without the seller having to cut the price aggressively.
Perhaps a pair of extreme examples will make the
concept clearer. A dollar bill is an asset with very
high liquidity. Anyone carrying a dollar bill (in the
U.S., at least), can “sell” that dollar for another dollar, a soda, or a pack of gum at a moment’s notice
and without having to cut the value of that dollar. A
house is an asset with very low liquidity. An individual seeking to sell a house would most likely hire
a real estate agent, list the property, leave it on the
market for a median of 90 days, and actually close
the transaction 30–60 days after that. Selling the
house will also incur a 6% realtor fee, taxes, and,
in order to speed up the process, the seller might
have to cut the price significantly.
These two examples, the dollar and the house, are
extreme examples of a liquid and an illiquid asset.
In reality, the majority of investments fall somewhere along the spectrum between the two. A stock
listed on a major stock exchange would qualify as
highly liquid, though unlike a dollar bill, in order
to sell a large amount of a given stock (say, millions
of shares), the seller would likely have to cut the
price of the shares. Similarly, a U.S. Treasury note is
a highly liquid asset, even though there’s no single
exchange for trading Treasury notes. Many other
fixed income assets, including corporate—especially high yield—and municipal bonds have lower
levels of liquidity that can make them challenging
to sell, especially in times of market stress.
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Table 1: Asset Classes & their Liquidity
Cash
More Liquid (Easy to Sell)
10yr Treasury Note
Large Cap Stock (NYSE)
Ginnie Mae MBS
Corporate Bond (A Rated)
Ginnie Mae CMO
Municipal Bond (A Rated)
High Yield Corporate (B Rated)
High Yield Municipal (BB Rated)
Real Estate
More Illiquid (Tough to Sell)
(Source: Janney FI Strategy)
It’s important to consider liquidity risk in constructing a portfolio, though the ability to take liquidity
risk varies tremendously among investors. An investor in or near retirement generally requires greater
liquidity, as s/he may soon begin drawing down
her/his investments—that’s a predictable liquidity
need, one that can be achieved with predictable
bond maturities or the sale of assets over time. A
small business owner might also require greater
liquidity in her/his portfolio to compensate for the
risk that s/he loses a contract and her/his income
slows for a year or two. By contrast, a young investor with a reliable job and income stream can take
more liquidity risk in a portfolio and thereby earn
a greater return over time. It’s also important to
understand that liquidity risks interact with other
forms of portfolio risk. A listed stock of a large
multi-national company might be more liquid
than a bond from that same company, but in other
Table 2: Investor characteristics that permit more/less liquidity risk-taking*
Can Afford More Liquidity Risk
+ Stable income
+ Large portfolio relative to spending
+ Longer time to retirement
+ Adequate life and health insurance
+ Low debt
Should Take Less Liquidity Risk
– Limited non-investment income
– Smaller investment portfolio
– Retired with risk of unexpected expenses
– Net worth tied up in real estate
– Underinsured
*Sample list only. Speak with your Janney Financial Advisor for advice specific to your situation.
respects, the bond would be less risky than the
stock. As an aside, a bond maturity, since it turns an
asset (the bond) into cash, is a source of liquidity in
which an investor can have confidence, particularly
for higher quality bonds.
To this point, the discussion of liquidity and your
portfolio has been more about definitions and
risk-taking ability, but the liquidity of various investments can also change over time. And, as the result
of a number of factors, the “real” liquidity of many
investments has been declining in recent years.
Historically, broker/dealers have provided liquidity to the markets, by serving as intermediaries
between sellers and buyers of investments. Losses
faced during the Global Financial Crisis in 2008
and 2009 meant that some of these broker/dealers
were shuttered, while many that survived reduced
the risks they were willing to take. In 2010, Congress passed and the President signed the DoddFrank Act, which instituted restrictions on many
of these intermediaries. The combination of these
market and regulatory forces has had many impacts
including a reduced willingness to provide liquidity
as a market intermediary, particularly for riskier or
more complex bonds.
Chart 1: Dealer Inventory of Corporate Bonds
is Down 80% from 2006
$300 bln
$250 bln
$200 bln
$150 bln
$100 bln
$50 bln
$0 bln
2006
2007
2008
2009
2010
2011
2012
2013
(Source: Janney FI Strategy, Federal Reserve Bank of New York)
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2014
This reduction in market liquidity, seeing as it’s
been several years in the making, is unlikely to
abate anytime soon (though the most inviolable
law of economics tell us that, if providing liquidity becomes more profitable, dealers will be more
willing to do it!). We can see the impact of that
weaker liquidity in some more violent bond market moves in mid-2014. Perhaps the best example
is the market volatility that surrounded bond
manager Bill Gross’ departure from his long-time
employer and his move to a competitor. Mr. Gross’
job change encouraged some investors to sell out
of their holdings of PIMCO funds and transfer
their assets to competing firms with more stable
management teams. The transfer of assets involved
PIMCO selling and competitors buying—imagine
it as too much water flowing through too narrow of
a pipe—which caused the prices of illiquid assets
such as high yield corporate bonds to drop rapidly,
even though there was neither a fundamental basis
nor a change in supply/demand dynamics to justify
such a price drop.
Compounding the reduced liquidity is the increase
of what we affectionately term “tourist investors”
in many riskier fixed income markets. This investor base, which might include foreign institutions
entering into the U.S. markets until returns look
better elsewhere, or individual day traders—who
want to trade bonds as if they were stocks—tend
to flit in and out of the markets for risky bonds.
Often, these tourists prefer exchange-traded funds
(ETFs) for the easy ability to buy and sell. While
the entry of these investors is positive for liquidity,
their sometimes rapid exits are not. Tourist investors fleeing ETFs can force these funds to sell their
holdings, and exacerbate what might have otherwise been modest market declines.
Chart 2: “Tourist Investors” have been Buying Illiquid Assets in ETFs
$60 bln




$50 bln
$40 bln
HY Corporate ETF (+208%)
Municipal ETF (+138%)
IG Corporate ETF (+25%)
Total Bond Market ETF (+80%)
Values represent the 5yr change in market cap of the
largest bond ETF in each sector as of Sept 30, 2014.
$30 bln
$20 bln
$10 bln
2009
2010
2011
2012
2013
(Source: Janney FI Strategy; Vanguard; BlackRock iShares)
All else being equal, the reduction in liquidity in
the markets for risky bonds (e.g., corporate high
yield bonds) means that investors should, over
time, hold a smaller portion of these bonds in
their portfolio. The simple reason is that, when
market or economic times get tough, investors will
find it harder to sell illiquid bonds, and their values will drop more quickly. In other words, liquidity will be at its worst exactly when you need to
sell! Of course, for investors with little need to sell
their bond holdings, illiquidity is irrelevant, as this
group of investors could simply hold their bonds
until they’re redeemed or mature. The good news
is that most liquidity-driven declines in the value
of investments recover over time, as was the case
during the Global Financial Crisis for corporate
bond values, for example. Nonetheless, everything else equal, weaker market liquidity is a good
reason to own a greater percentage of high-quality
assets in your portfolio.
This report is for informational purposes only and in no event should it be
construed as a solicitation or offer to purchase or sell a security. The information
presented herein is taken from sources believed to be reliable, but not guaranteed
by Janney as to accuracy or completeness. Any issue named or rates mentioned
are used for illustrative purposes only, and may not represent the specific features
or securities available at a given time. For investment advice specific to your
individual situation, or for additional information on this or other topics, please
contact your Janney Financial Advisor and/or your tax or legal advisor.
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2014