What Price Illiquidity?

From aiCIO Magazine's February issue: Taking on, and getting paid, for illiquidity. Elizabeth Pfeuti reports.

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Institutional investors are meant to be fans of, and are natural candidates for, the “illiquidity premium.” It ties in with their long-term investment horizons. Few are forced sellers, as they (should) have such well-diversified portfolios and can usually find something to offload easily.

That said, how many investors can actually quantify an illiquidity premium? In the post-financial crisis era of total transparency and up-to-the-minute, accurate data, shouldn’t they at least have an idea of what it’s worth—and what it could cost them?

John Stopford, head of fixed income at Investec Asset Management, told aiCIO that when addressing high-yield bonds he counts the first 100 basis points as an additional premium that he is earning for the lack of liquidity inherent in the security. He is willing to give up this 1% in the event of having to sell the bond quickly. After that amount is removed, if he is still happy with the return profile, then the bond stands more of a chance of ending up in his portfolio. 

To highlight why illiquidity has become such an issue, consider a statistic bandied about in the market: If mutual bond funds had reduced their positions by 5% in 2007, investment banks would have had to increase their balance sheets by 10%. Today, these balance sheets would have to double if the same sell-off were to occur. Whether the numbers are perfectly accurate or not, banks have certainly been made to shrink their balance sheets and liquidity is a much bigger deal than it was pre-crisis.

Of course, fund managers’ time horizons are nowhere near as long as pensions’, and redemption demands from clients often mean asset managers are forced to sell items in their portfolio that they would rather keep. Yet there are knock-on effects from fund managers’ actions to those whose assets they hold, so wouldn’t a similar method of quantifying the premium be useful for investors, too?

Melissa Brown, senior director of research at risk specialist Axioma, said: “Investors always need to think about liquidity, not only when they are buying, but also keeping in mind potential issues when they go to sell.”

But they can’t think about liquidity in a vacuum, says Brown. “There are three ‘prongs’ to an investment decision—potential return, risk, and trading costs (which are driven by liquidity). So a buy decision needs to compare the expected return after taking into account the cost of buying and selling with the risk the asset will add to (or take away from) the overall portfolio.”

Knowing liquidity needs—and tolerances—is essential for institutional investors, says David Bennett, managing director at investment consultant Redington. The firm stress-tests its clients’ liquidity in terms of both benefit payments and potential collateral requirements—which has become more important with the increasing use of derivatives and hedging. 

With fixed-income, the higher up the risk curve the bond is, usually the more illiquid it becomes. Higher transaction costs (and volatility) need compensating with higher returns, especially as liquidity typically deteriorates in a forced selling environment. The most illiquid securities can offer 1-1.5% premium, Bennett said, which is generally considered sufficient compensation. However, there is no hard and fast rule to make the calculation. 

“The liquidity premium is high at the moment, but that has not always been the case,” says Bennett. “Due to the long-dated nature of their liabilities, most funds can afford to take advantage of the liquidity premium. A mature pension fund will need more liquidity than a relatively young one and those looking for a scheme buyout may find some providers will not be able to take illiquid assets as part of the deal. How each investor quantifies their appetite is—and should be—different.”

Bennett asserts that recognition of the liquidity of an asset should be taken into consideration at the point of classification and that the important role of illiquid assets has been becoming more widespread. He notes that Redington’s preferred approach now explicitly incorporates liquidity “buckets” into asset allocation discussions.

However, not everyone agrees that investors should worry about this.

Mark Benstead, head of credit UK at AXA Investment Managers, says: “In the secondary market it’s all pretty illiquid—and this illiquidity is mostly priced in. Investors don’t really have to worry about being forced sellers of most assets as they usually do not buy anything so exotic so there is not a buyer willing to take it off their hands.”

Private placements or direct investments are usually made with the understanding that the investor is in for the long-haul, so illiquidity, which is an inherent part of the deal, should be understood and priced in, says Benstead.

However, banks’ balance sheets are still too big for some regulators and as the bond boom seems to be over, it might be time to dip a toe into portfolios and test the (il)liquidity.