Managing Liquidity in a Changed Market
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
It is no secret that liquidity in the secondary high yield corporate bond market has changed since the financial crisis, especially with the implementation of certain banking regulations that limit market making activities by the large banks. In response to the reduced liquidity created by these regulations, last year, the SEC came out with some proposed rules to address liquidity within open-ended funds and ETFs. The proposal seeks to have funds better monitor and manage their liquidity by classifying securities into liquidity groups based on the number of days it will take for a security to be sold without a material impact on price, and only a certain portion of the portfolio would be able to be held in securities that would take a longer period of time to sell. We are still awaiting the final rule, but questions abound to the proposal.
For instance, how do you know if you are able to sell and what the “liquid” price of a bond/loan is until you actually enter an order to sell it? While high yield bond mutual funds and ETFs are easily traded, the bonds themselves are not. This is a negotiated market, where you are finding buyers and sellers each time you want to make a trade. In some cases, you may not know if there is a bid (buyer) for a security until you put out an offer in the market of that security.
Additionally, how would you quantify a “material” change in price? If you are trying to sell in the midst of a market downturn, prices can be volatile. Additionally, if bad news comes out on a company, it certainly isn’t unusual to see prices move down 5, 10 or even more points in a trade or even a quote. By the SEC’s definition of liquidity, if you are selling a very liquid security on negative news or there is negative market sentiment (during periods of outflows from the asset class) and are now selling five points lower than the last trade, does that somehow make the bond/loan an illiquid security because you were the first to make the trade at a much lower price? There is still no quantifiable definition on what “material” means from a price perspective, or what a fund is to do when there is an across the board sell-off and there are no bids to be found. Could this create a scenario by which an entire market can be defined as “illiquid” and a repeat of 2008 could happen all over again due to regulations, not underlying valuations?
The SEC proposal is focused on how quickly you can sell something. With that, we would expect to see smaller funds and managers in a much better position to deal with potential restrictions—it is generally easier to sell smaller positions than larger positions. While some funds may have hundreds and even upward of a thousand individual credits, if it is a huge fund, the positions sizes can still be pretty large. For instance, the largest high yield ETFs have average position sizes around $14-15mm. How much more difficult is it to sell a $15mm position versus a few million dollars of a security that may be held in a smaller fund? Even if the $15mm was broken up into smaller chunks to sell, the continued selling pressure on the security clearly will have some pressure on the price, thus potentially triggering the “material” change in price.
Interestingly, the two largest ETFs in the high yield space have minimum tranche size thresholds—meaning they have it as part of their mandate to invest only in the larger tranche sized deals and/or companies with a certain amount of total debt outstanding. The basic premise here, right or wrong, is that tranche size indicates liquidity. We have always felt these arbitrary limits put these funds at a disadvantage because it means they were excluding a large portion of the high yield market from their investible universe. The last we looked, these tranche size constraints excluded over half of the individual bond tranches in the overall high yield bond universe.1 But if we were to see the proposal discussed above take effect, would we see these very large funds work to change their mandate and expand their investible universe so that they can lower their position sizes to better manage liquidity? If so, this may well serve to increase the activity and potentially bid up many of the smaller tranche size names these funds currently overlook.
Again, the SEC so far has just made a proposal and nothing has been finalized and questions abound, but it is clear that liquidity is an area of focus, especially as funds manage redemptions. While we wait, we have proactively worked to adjust our portfolio to improve liquidity. As we have recently discussed at length, we are seeing the most recently issued securities as among the most liquid in today’s market so we have adjusted our strategy to allocate a portion of the portfolio to newly issued bonds. As an active manager, we have the flexibility to adjust our portfolio as needed and continue to expand the number of holdings and reduce position sizes. With this strategic new issue allocation, and the fact that we are a smaller manager and have access to the entire high yield corporate debt market, including both high yield bonds and floating rate loans, and are not constrained by tranche sizes, we believe that we are positioned well in advance by addressing these liquidity concerns as we move forward.
1 See our piece “Active Management: Selectivity and Flexibility” for further details.