NEW YORK--(BUSINESS WIRE)--Despite indicators of reduced market liquidity for corporate bonds, most bond managers have not increased the level of liquidity they hold in their portfolios due to an aversion to "cash drag" on fund performance. Limiting cash drag may allow some fund managers to avoid underperforming their benchmarks for 2014, but it can eventually expose funds to bouts of market illiquidity and exacerbate fund losses during market shocks, says Fitch Ratings.
If a fund's redemptions were to spike during a market dislocation, a lack of sufficient cash and liquid assets within the fund could force untimely bond sales. Forced sales could result in severe net asset value drawdowns, particularly when secondary market liquidity is limited.
The unfortunate side effect of holding higher fund liquidity, however, is fund underperformance, which could lead to net outflows. Neither situation -- holding excess cash now or being exposed to illiquidity risk later -- is optimal, but the dynamic represents a headwind, particularly notable with asset managers overseeing large fixed income portfolios.
Bond market illiquidity concerns have centered in part on the shifts in the balances of corporate bond holdings between various market participants. One barometer of the risk can be seen in the ratio of corporate and municipal bonds in the market (excluding inventories at brokers and dealers), relative to the amounts actually held at the brokers and dealers. Using data from the Fed's quarterly Z.1, as of second-quarter 2014, non-broker/dealers now hold 18.4x the amount of corporate and municipal bonds at broker/dealers. The same ratio is up from just 8.0x as of year-end 2009. A chart of the relationship over the recent past is shown in the link below.
As long as asset managers hold significantly higher amounts of corporate and municipal bonds relative to the brokers and dealers, the illiquidity concerns are likely to persist unless intermediary platforms emerge.
Forms of defensive positioning that bond managers can employ typically include holding more cash and treasury/agency collateral. Investment managers have only modestly increased liquidity levels they maintain within funds. Between 2007 and second-quarter 2014, average cash and treasury/agency collateral as a percent of U.S. corporate and municipal bond fund assets only increased to 13% from 10%, according to data from Lipper. Whether this is sufficient and its longer-term impact on performance remain to be seen.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.