Managing fixed-income liquidity in a crisis
30 March 2020 | Topical insights
Commentary by Kunal Mehta, senior investment product specialist
The coronavirus pandemic struck just as we were approaching the end of an extended credit cycle. With valuations looking stretched, even a minor economic upset might have been enough to tip markets into correction. But the severity of the coronavirus crisis has delivered a much more substantial shock. This has led to the highest levels of market volatility since the global financial crisis of 2008.
As economic growth slows as a result of the pandemic, the view from our fixed income credit team is that this is highly likely to lead to a global recession. What is still uncertain is just how deep and prolonged that downturn will be.
In response to the crisis, investors have scrambled to get out of risk assets. We can liken the situation to the panic buying that has hit the UK high street in recent weeks, leaving supermarket shelves stripped bare. But rather than stocking up on toilet rolls and pasta, investors are hoarding cash.
This has contributed to large fund redemptions, resulting in many fixed income funds rushing to sell their most liquid assets, which are typically short-duration and high-quality bonds.
Sellers by far outweigh buyers at present, not least because banks—which traditionally provided liquidity—have come under pressure themselves as their credit lines are drawn and it becomes harder for them to operate as they have done in the past. With banks less able to act as market-makers, liquidity is in short supply. This has led to higher transaction costs and widening spreads.
Many investors are looking to central banks and governments to provide a solution. We’ve already seen huge fiscal stimulus, loan guarantees, interest-rate cuts and a resumption of quantitative easing. Central banks are striving to provide near-unlimited liquidity through bond purchases and money-market interventions. And we could well see much more in the weeks and months to come. But these interventions will take time to have an impact; what’s more, they will need to be sufficient to change market sentiment.
As such, in essence there are two phases to the correction. The first is investors’ ability to turn assets to cash—which is what central banks will continue to help achieve—and for fund outflows to bottom out. We expect this to happen soon. The second phase is the economic impact, which will take longer to come through.
Fixed income index funds
All of this leaves bond investors grappling with the questions of price discovery and fair value in extremely volatile conditions. Liquidity premiums have increased and there have been large pricing dislocations across the fixed income asset class. Some pricing differences are to be expected; after all, as bonds typically trade over the counter, a single market clearing price is not always possible. However, recently we have seen larger dislocations in pricing than normal.
At Vanguard, we’ve been preparing for the next crisis since the last one ended. We continually stress-test our portfolios and—more importantly—assess what we can do about any stresses that arise.
In the current extreme conditions, our scale brings us significant benefits. We have a large and diversified client base and thus, at times, have the ability to internally match natural buyers and sellers – and provide better prices for both. Our strong relationships with a number of market participants also help us to trade more effectively when markets are more volatile.
Minimising tracking error
Furthermore, minimising tracking error and managing liquidity are a priority for our global fixed income and risk management teams.
Since our fixed income index funds use a sampling approach to find the optimal balance between index replication and cost, there will always be small differences in performance between the funds and their respective benchmarks.
But this sampling methodology allows our trading and credit research teams to select the bonds that best replicate the characteristics of the underlying benchmark at low cost and while still minimising tracking error. The portfolio management team and credit research team also consider the liquidity of each bond as part of this process.
We use swing pricing to protect our existing investors when redemptions are high. This ensures that when transaction costs are elevated, buyers and sellers take more of the strain than those who remain invested. It is important to note that pricing differences do not accumulate and should smooth out over time. And funds with swing pricing can exhibit higher volatility than what is actually occurring with the underlying assets.
Our multi-faceted approach to managing liquidity includes pre-emptive actions such as the on-going assessment of a fund’s liquidity and the assessment of bonds purchased by our credit research analysts, as well as using a range of liquidity tools on a routine basis. These tools include offsetting redemptions and purchases within the fund, factoring in pending portfolio rebalancing activity and selling securities in the market. There are also non-standard tools which we use on a less frequent basis, including deferred redemption, where a fund may fulfil a large redemption over a period of several days.
Fixed income active funds
For our active fixed income funds, our defensive stance has placed us in a strong position. Our Global Credit Bond Fund and Emerging Markets Bond Fund had both lowered risk over six months ago on the view of rich valuations. As such, while many active bond fund managers are now looking to sell assets, decrease risk and take on liquidity where they can, we are able to selectively buy securities, seizing opportunities that are now at much more attractive valuations.
Though we have not been immune from the need to raise cash, our liquidity management process has allowed us to do so in our active funds in an orderly way.
Above all, our experience tells us markets move in cycles and typically recover over the long term. So we believe that the most important message is that investors should stay the course. None of us should underestimate the scale of the current crisis, but nor should we let its immediate impact cloud our long-term view.
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