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There’s No Profit in Panic: Steering Clear of a Bond Liquidity Crisis

14 July, 2014 by Mark O'Brien in Commentary

Readers of the financial media have no doubt observed the number of articles about potential liquidity problems in the bond market, especially the corporate bond market, which has become bloated with new money and new investors in the wake of government zero-interest programs, like Quantitative Easing,  designed to get the economy going again.  Written by academic and government economists and market commentators, these thought pieces are prospective in nature. That is to say, there isn’t a problem now. But these writers think there could be, when the problem could cascade through the financial system, like the collapse of the residential real estate market in 2007-8, leading to even bigger problems in related areas of banking and commerce throughout the world.
Water letterIn terms of a definition, “Market liquidity” is one of those important-sounding terms that individual investors are generally aware of but not too sure why. The standard line about market liquidity is that it doesn’t matter until it does, when it is the only thing that matters. In this regard market liquidity is like oxygen. We know it’s absolutely essential but who has time to think about it? So you take it for granted, until there is a problem, when you cannot think of anything else.

So what is market liquidity? It’s hard to define, you know it when you see it. If you have to sell your house in a day, you won’t get a very good price. Cars have somewhat better liquidity; you could conceivably sell one in a day, but you would really have to work at it. And if everyone else on your block were also trying to sell his car on the same day, you would have even more trouble. So it is that a lot of very valuable things take time to sell, and you are in trouble if you put yourself in the position of having to sell right away. And it is more complicated than that, because each market is different. And investor sentiment can transform a market in the twinkling of the eye. Market liquidity depends on many many factors, and if one or two of them go awry, you may not be able to sell the asset at any price. Yes, markets freeze up in times of severe stress. In 2008-9, this happened with preferred stock in banks and financial institutions and in many forms of mortgage-backed securities.  Bond buyers did not want to get involved, at any price.

If this were to happen again, say commentators, it might happen first with lower-quality bonds that do not mature (return capital) for 20 or 30 years. These long-maturity low-quality bonds have been scarfed up by investors in recent years. So long as markets remain stable, with no shocks, or geopolitical surprises, investors will hang onto them. But if there are some unpleasant surprises and investors see prices drop 25% in a few days, they usually decide they want out, immediately.  That’s when the big problems occur. In the trade observers compare it to a fire in a crowded auditorium, when everyone heads for the exits at the same time. It is awful.

Would we want to take advantage of such a market liquidity event?  The short answer is I don’t think so. That’s because we would have to prepare for it by keeping  a huge reserve in cash waiting for the fateful moment, which might not even happen.  Were we to have such a reserve, I am afraid that we would act too early.  What’s the quip about economists predicting nine of the last two recessions?  For sure we would be too early, or too late, and either feel the full force of the panic or none of the benefit of the recovery.  Rather we would take another approach. We try to build a ladder of bond maturities, with at least one bond maturing (coming due) each year, so we can wait out liquidity panics.  It might happen that we have some money to put to work at the height of a crisis, but only some, and certainly not the entire portfolio.  In our experience, that kind of perfect timing only happens in stories, not the real world.

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