By Chris Redmond
The magnitude of changes to liquidity in the credit market should be encouraging investors to protect themselves or even capitalise on it. But while research abounds, there has been an overwhelming lack of practical suggestions and action.
Given the extent and nature of these changes, institutional investors now need to review the appropriateness of fund liquidity terms and their asset managers’ investment styles. Specifically they should be aware that fund and liquidity terms are important – liquidity of commingled investment products should be appropriate for the liquidity of the underlying assets.
Fund terms should protect the interests of long-term investors. Opting for a separate account (or ‘fund of one’) represents a solution for larger investors and can largely shield them from changes in market liquidity. Pricing mechanisms that charge investors a fair amount equivalent to transaction costs for subscribing and redeeming (or seeking to match investors) make commingled vehicles safe for investors of all sizes.
Clients should review liquidity and fund terms of all commingled products they invest in. Indeed, an evolution in commingled fund liquidity terms would reduce risks associated with the new credit market liquidity regime, enabling clients to negotiate better terms, or shift to products that are better structured.
The optimal size of a fund for a given investment approach is now likely to be smaller. Higher turnover strategies seeking to exploit small anomalies appear challenged, and we are also concerned about the validity of credit strategies employing a stop-loss discipline in an environment of generally higher volatility and where prices gap during periods of stress. However, one could argue there has never been a better time for managers to effectively apply a contrarian, fundamental value-type approach.
We expect the illiquidity risk premium to be, on average, higher to compensate investors for the new regime, and investors should acknowledge this and exploit it where possible. This presents an opportunity for institutional investors with a long investment horizon to be able to ‘lock up’ their capital and generate higher returns.
The so-called Taper Tantrum and US Treasury Flash Crash will still be fresh in credit investors’ minds as examples of challenging market behaviour and volatility, but also as valuable windows into possible future scenarios. While the markets quickly calmed, both events occurred during an overall environment of generally benign economic conditions and positive risk appetite amongst investors.
We worry about how credit markets might behave during a period of genuine macroeconomic uncertainty where investors’ asset allocations are materially changing and they are all trying to sell credit assets, which is why now is the time for action.
Chris Redmond is global head of credit research at Willis Towers Watson
