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Transcript
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. WWW. JANNEY.COM • © 2014, JANNEY MONTGOMERY SCOTT LLC MEMBER: NYSE, FINRA, SIPC • REF. 1305475 • INTEREST RATES 2014 SERIES • PAGE 1 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) WWW. JANNEY.COM • © 2014, JANNEY MONTGOMERY SCOTT LLC MEMBER: NYSE, FINRA, SIPC • REF. 1305475 • INTEREST RATES 2014 SERIES • PAGE 2 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. WWW. JANNEY.COM • © 2014, JANNEY MONTGOMERY SCOTT LLC MEMBER: NYSE, FINRA, SIPC • REF. 1305475 • INTEREST RATES 2014 SERIES • PAGE 3 2014