by Richard Phillips, Chief Investment Officer
and Zachary Schwartz, Client Relations
Executive Summary
Liquidity plays defensive and opportunistic roles for investors
Investors are willing to forego a certain amount of return in order to maintain liquidity
Unfortunately, liquid fixed income investments such as government bonds and listed corporate bonds are now so expensive that the return forgone in order to achieve such liquidity is inordinate
There are a number of high-quality, low-risk investments in Canada, which generate strong yields and only require a modest sacrifice in liquidity
Investors can exploit outsized premiums in exchange for tolerating only modest illiquidity in the Alternative Yield Universe
In circumstances ranging from the extreme to the mundane, liquidity helps investors preserve assets and pursue accretive acquisitions. In this report on liquidity in fixed income portfolios, we examine: When families need or want liquidity; how much liquidity is enough; the intersection of fixed income yields and liquidity; appropriate compensation for illiquidity; and why active management of diverse Alternative Yield allocations improves overall portfolio liquidity.
Investors Need Some Liquidity
Liquidity may be needed for unexpected demands, or, on the other hand, in order to take advantage of unexpected opportunities.
We hope that readers meet more opportunities than exigencies. The table below provides an inexhaustive rundown of liquidity’s defensive and opportunistic applications (times when one might need, or want, substantial liquidity):
Notably, none of these applications likely demand daily liquidity.
How Much Liquidity is Necessary?
For most investors, daily liquidity is generally an unnecessary and expensive feature of traditional, publicly traded bonds.
A previous East West research article, “Rebalancing: Canadian Edition,” examined how regularly rebalancing portfolios improves returns and dampens volatility. The optimal frequency, based on our research, is quarterly; however, almost all rebalancing strategies outperform buy-and-hold. This research suggests that most investors, as opposed to traders, do not need daily liquidity as part of a long-term investment strategy.
At East West Investment Management, we encourage replacing a portfolio’s traditional bond exposure (e.g. 40% of the portfolio in the graph above) with Alternative Yield strategies. As we wrote in our report, “Too Late to Stop Now – The Case Against Bonds”, investors likely face low future real returns or, potentially, sizeable capital losses on traditional bond holdings – in other words, an unappealing risk/reward setup. One debatable advantage of traditional fixed income holdings is that they provide investors with daily liquidity. However, most long-term investors do not need that daily liquidity; and, occasionally, they must take a markdown to access it.
Public market bonds’ volatility and frequent positive correlation to equities during periods of market stress reduce the advantages of their daily liquidity.
In yet another article, “The End of an Era,” we observed, “instead of providing safety [bonds] may further drag down a traditional portfolio if the correlation between stocks and bonds reverts to a positive one.” This was borne out during the Covid crisis. Investors looking for quick cash, whether to deploy into mispriced securities or to meet margin calls, might have begun with securities marketed as “liquid” – e.g. the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE: LQD). Those selling LQD on March 18th, 2020, in order to access liquidity, crystallized a year-to-date (YTD) loss of almost 18%.
Bond losses were less dramatic in Canada. For example, those seeking liquidity from the iShares Core Canadian Bond Index ETF (TSX: XBB) on March 18th, realized a YTD loss of just over 9%.
In short, those looking to traditional fixed income as a ballast against equity market volatility and to take advantage of its daily liquidity, were sorely disappointed.
Serious illiquidity can cost investors dearly.
Though we believe daily liquidity is unnecessary for investors with a long-term orientation, at the other end of the spectrum, extreme illiquidity is generally unwise. Many HNW Canadian investors already have some measure of illiquidity embedded in their net worth. These illiquid holdings might include shares of private (e.g. family-owned) operating businesses; concentrated and/or restricted stock positions; and real estate. In exigent or “defensive” circumstances, too much illiquidity can prove costly.
Consider two “defensive” scenarios. Mr. and Mrs. Jones decide to divorce (divorce rates in Canada are about 50%). They are worth approximately $75M, heavily weighted in Mrs. Jones’ family business, real estate, and blue-chip private equity funds. The settlement calls for Mr. Jones to receive $25M. To meet these obligations, in addition to her legal costs, Mrs. Jones can sell some of her assets at a discount to their Fair Market Value (also potentially triggering tax liabilities) or borrow against these illiquid holdings on suboptimal terms.
In another scenario, Mrs. Jones’ family business, supplying the airline industry, is grounded. She and her siblings need to suspend the dividends that support their lifestyle needs and, in fact, need to recapitalize the business to meet its debt covenants. This is an easier undertaking for those family members with more liquid holdings.
The Jones’ illiquidity also impairs their ability to opportunistically invest in mispriced public equities and to take advantage of tax planning options (e.g. when to crystalize capital gains or losses). Their holdings are insufficiently liquid to allow strategic portfolio and tax rebalancing.
Clearly, too much illiquidity can compromise family wealth in exigent circumstances and can narrow opportunities across the board.
The Goldilocks approach: not too little liquidity and not too much.
In our experience, a diversified fixed income portfolio with liquidity under a year generally provides sufficient access to cash without the costs (lower returns and higher volatility) of daily liquidity. In the scenarios discussed above, reasonable liquidity enables long-term investors: to regularly rebalance; to protect against forced asset sales; and, for more sophisticated investors, to tactically utilize short-term leverage.
Notably, the East West Alternative Yield Model Portfolio is quite liquid: half of the portfolio can be converted to cash in one month and seven-eights in less than a year. At the same time, the portfolio provides a strong yield:
Yield Enhances Liquidity
A yield-producing portfolio mitigates the need to liquidate other assets.
As we noted in a previous research article, “Manager Selection: East West’s Approach,” we believe that “consistent cash flows provide a counterweight to equity market volatility. Predictable cash injections enable clients to avoid liquidating equity positions during periods of underperformance, particularly for those relying on passive income to meet lifestyle needs, and to take advantage of buying opportunities.”
Consider, for example, if the Joneses had a reasonable and reliable passive income stream to supplement the dividend income from their operating company. It would reduce their vulnerability during periods of distress or, put differently, improve the overall liquidity profile of their holdings.
Traditionally, publicly traded bonds generated meaningful cash flows. But this is no longer the case. The image below, from the Financial Times and Ice Data services, puts yield compression into sharp relief: more than 60% of today’s global bond market yields less than 1%; more than 85% of the global bond market yields less than 2%[1]. By contrast, almost 75% of bonds were trading with yields north of 5% in the late 1990s.
Many investors have reached for yield by extending duration and shifting their portfolios to lower-rated corporate bonds – increasing their exposure to both interest rate and credit risks. LQD, referenced above, yields 2.89% at time of writing (a negative real return after tax); nearly half (47%) of its holdings are in BBB bonds; and it has an effective duration of over 8 years[2]. We prefer to exclude this sort of return-free risk from clients’ portfolios.
Strong fixed income yields make for better equity investors.
Ongoing cash flows help investors weather the ups and downs of their equity portfolios. Stability in cash flows – a form of liquidity – naturally hedges against public equities’ volatility: it provides purchasing power during market drawdowns and softens the impact on portfolios’ blended return. At a psychological level, we believe that meaningful real yields can help reduce the fear factor for investors, facilitating improved decision-making on equity allocations.
Cash-flow generating investments only improve portfolio liquidity when their after-tax yields meaningfully exceed inflation. These days and for the foreseeable future, investors will have to look beyond traditional investment grade bonds for that cash flow and liquidity combination.
Pricing Liquidity
Traditional fixed income investors are likely paying too much for liquidity.
If traditional fixed income investors increase durations and lower credit quality, yet still suffer from negative real yields, high volatility, and positive correlations to equity markets, they are overpaying in our view. In those cases when Canadian investors genuinely require daily liquidity, we suggest slightly elevated cash holdings in a low-inflation environment is more attractive than most unhedged, publicly traded fixed income.[3]
Investors are well-compensated for modest illiquidity.
Those prepared to forego superfluous, i.e., daily, liquidity can enjoy much higher returns. As mentioned above, the East West Alternative Yield Model Portfolio’s weighted average liquidity is under a year, which satisfies the liquidity needs of many investors. Most assets are liquid within one to three months.
In exchange for foregoing daily liquidity, investors’ annualized return since inception is more than 2.5x the S&P Canada Aggregate Bond Index and more than 6.5x the FTSE Canada Universe Bond Index, if invested in the Model Portfolio. As we have made clear, East West does not believe that a modest level of illiquidity materially adds to portfolios’ risks.
Highly illiquid investments sometimes offer inferior risk/return profiles.
In our experience, fixed income investors, particularly those assessing returns on committed capital, often see diminishing premiums when moving liquidity out beyond a year.[4]
Though beyond the scope of this article, for a critique of illiquid private returns versus public markets, see this short piece from the Financial Times: “New analysis estimates performance of PE funds, net of fees, matches public equity markets,” https://www.ft.com/content/803cff77-42f7-4859-aff1-afa5c149023c
Active Management of Alternatives
Diversification improves the liquidity of Alternative Yield allocations.
Investing in multiple Alternative Yield funds with limited correlations both to public markets and to one another, creates a fixed income portfolio more liquid than the sum of its parts. We would similarly posit that an investment in eight stocks is more liquid than a concentrated position in a single company.
Most Alternative funds retain the right to gate redemptions and judiciously deploy gates to protect investors from the deleterious impact of a rush to the exits. None of the funds in the East West Alternative Yield Model Portfolio were gated during the Covid crisis.
Diversification between real asset funds, private lending funds, credit hedge funds, and specialized funds reduces the likelihood of redemption restrictions across the whole portfolio. Similarly, diversity within each segment of the portfolio provides an additional hedge. For example, one of our lending funds invests in receivables and asset based loans and is diversified with over 150 positions, across sectors, in its portfolio. Another of our lending funds maintains about 50 low-leverage loans with North American SaaS companies. Each of the funds is well diversified, while holding both further reduces the chance of redemption restrictions and improves overall portfolio liquidity.
Lower volatility and sustained yields mean more liquidity.
In our judgement, a portfolio is only liquid when investors can raise cash without forcing a substantial capital loss. We rebalance to maintain diversity and manage risk in the Alternative Yield Model Portfolio.
Active management of a diversified portfolio of Alternative Yield funds resulted in lower volatility than both the S&P Canada Aggregate Bond Index and the FTSE Canada Universe Bond Index.
Every family is different.
Each investor has different liquidity needs. East West builds bespoke portfolios for our client families. Families who have sold their operating businesses or maintain high earned incomes, can generally tolerate higher levels of illiquidity. Conversely, those who still own operating businesses or are retired may require a higher level of liquidity.
Conclusion
Investors tend to overpay for illusory daily liquidity in available fixed income portfolios when they can instead benefit from outsized returns from actively managed Alternative Yield allocations. At East West, we encourage shifting from high-risk/low-return bonds into Alternative Yield investments with robust liquidity characteristics.
[1] Figures as of June 30th, 2020.
[2] Subject to individual tax circumstances.
[3] For an academic perspective on illiquidity premiums for corporate bonds, see pages 69-72 of “Liquidity and Asset Prices,” by Yakov Amihud, Lasse Heje Pedersen, and Haim Mendelson of NYU and Stanford, http://pages.stern.nyu.edu/~lpederse/papers/LiquidityAssetPricing.pdf
[4] Where the risk/return is unavailable through other vehicles, it may make sense to incorporate a small number of less liquid funds into the overall Alternative Yield portfolio.