Playing With Fire: Illiquidity In The Bond Market - Interview With Ashish Shah Of AllianceBernstein

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Includes: JNK
by: Jay Unni, M.D.

Summary

Bond market illiquidity can drive huge price dislocations, like the one in January-February of this year.

Many of the factors contributing to illiquidity are not adequately recognized by market participants.

Astute investors in the high-yield market may be able to take advantage during these price dislocations.

AllianceBernstein (NYSE:AB)'s Head of Fixed Income, Ashish Shah, put out a paper, Playing with Fire, in late 2015 about the risks posed by increasing illiquidity in the bond markets (NYSEARCA:JNK). While numerous other market analysts and credit strategists were pointing to the risks posed by increasing regulation, Mr. Shah added additional insights on the risks posed by more retail participation in a mad grab for yield, new standards for measuring risk that decrease institutions' tolerance for volatility, massive leverage in the markets - partially resulting from the rise in risk-parity funds, and a rise in cross-border borrowing and associated hedges that function as another sort of leverage in the market.

In the face of these risks, Mr. Shah recommended several strategies: diversifying across sectors with different liquidity characteristics, avoiding crowded trades that can quickly sour, increasing levels of cash to take advantage of price dislocations, investing with bonds with attractive yields to maturity, and, in an interesting twist, considering less-liquid private debt markets for their higher yield - after all, there's no point in paying a premium for liquidity in public markets if that liquidity might dry up at any moment.

The central problem with illiquidity is that small events can trigger huge price dislocations. In January-February of this year, we saw these risks manifest when a sell-off in China sparked a massive decline in bond prices - especially in the high-yield sector. I wanted to get Mr. Shah's take on these developments in the bond markets, and his insight on what the path might look like going forward.

Interview conducted March 14, 2016.

Jay Unni: Thank you so much for taking the time out to do this. I read "Playing with Fire" and I thought it was really insightful. People who read that and understood the views there were probably able to weather the storms of the last couple of months better than most.

I wanted to just clarify a few of the things you brought up there, to question some of the assumptions, and get an update of how your views have changed over the last couple of months.

Starting with the regulations. That's something a lot of people are paying attention to. The decrease in proprietary trading in the banks and the need to strengthen balance sheets has decreased the ability of market makers to take the opposite side of trades. I wanted to see if you had more to say about that now. I know that it's something that people are paying attention to; do you think people are adequately aware of all the risks? Is there more that people are not seeing?

Ashish Shah: I think that there has been enough scrutiny and experience with the new mode of operating that most asset managers have experienced firsthand that there isn't going to be liquidity. It had been viewed as more idiosyncratic, like, "Why aren't you doing a good job for me?" Now it's being viewed as systemic - it's the entire industry that's having a challenge rather than one dealer not doing a good job for one asset manager.

I also think there isn't a full appreciation of the impact of ongoing development of regulations - because they haven't stopped right? We are still implementing aspects of Frank-Dodd, so that's going to continue to have an impact on market liquidity.

JU: That's a good point. They have this delayed timeline for introducing a lot of those regulations. As they continue to kick in, it will be something that investors have to watch out for.

One thing that you touched on a little in the paper is that if banks are decreasing proprietary trading, the main participants in the market are all subject to redemptions. Specifically, something that I have read elsewhere and talked about is that the risk of redemption by sovereign wealth funds. A lot of the biggest sovereign wealth funds have been funded by commodities. With the commodity sell-off, there is this risk out there. I was wondering if you have any views on that.

AS: I think what we lay out in the paper is something completely different. The vast majority of the money still isn't subject to daily redemptions. It's mostly longer term oriented money from a redemption perspective. However, the portion of the market that is retail and subject to daily liquidity has grown meaningfully over the last several years, as retail has sought out income generating assets.

So the rise of retail, particularly in strategies like credit and high-yield have led to more of this "boom bust" dynamic of money flows in and money flows out and creates volatility in the market from a retail perspective in these markets like high-yield.

The thing on the institutional side is less about sovereign wealth money redeeming, and more about the use of VaR. Rather than creating full redemptions, it leads to a procyclical risking and de-risking dynamic across that user-set.

Combine that with what's going on in retail. The two things play with each other. Retail starts selling and it drives prices down, causing derisking across VaR based management products. It exacerbates until it burns out, then retail starts buying and suddenly things gap higher, which is a pretty good description of what we've seen over the last two months.

JU: The other thing you brought up was about risk-parity funds taking on leverage to match volatility to other asset classes. That was something I really hadn't read elsewhere or seen elsewhere, and I thought it was a really great insight. Do you view that as also a contributor to this correlation across asset classes that we've seen? Risk parity funds having to take down risk across everything?

AS: I think risk-parity funds are reasonably thoughtful about where they are taking down risk, but it does factor in to the volatility they end up seeing. It's a more active rather than static investment process, and a more pro-cyclical, momentum-based investment style. Momentum-based investment styles can create a lot of volatility in a market like this.

JU: One of the other things you brought up was the increase in borrowing across currencies. I was wondering - are you taking a view on exchange rate direction? There have been a few people talking about the increase in dollar denominated debt over the past few years. With this recent rise in the dollar, borrowers might be running into some issues on that. Are you taking a view on that? Or are you making the point that there is a possibility of huge volatility?

AS: It's more the latter, and let me explain what we mean. If you're a European investor and you hedge into Euros, if you see depreciation in the Euro during periods of stress, that can force you into selling bonds into the market. There's a certain set of circumstances where you can get that, and others where you're not going to. Without question, currency volatility is a form of leverage in the market.

It's really concerning when you have the U.S. tightening liquidity, while Japan and Europe are easing liquidity and pushing investors in those markets to take more risks. That ends up being problematic because they can go out and buy dollar-denominated securities, hedge them back to euros, and run into challenges if the euro depreciates or the yen depreciates.

So far what we've observed is that, in general, those depreciations haven't come during periods of heavy stress. More recently, we saw the euro and the yen rally into the period of stress. What you would have to worry about is if you got into a stress-environment that was a dollar-strengthening environment. That would be quite interesting. With the concerns around China, it would likely stem from some volatility in the Asia region, which tends to be highly dollarized.

JU: Great, thanks for that clarity. The recommendations you made, keeping a lot of cash, having some puts to protect yourself, make a lot of sense. You mentioned using synthetic derivatives to get additional liquidity. I wondered if you could talk a little bit more about that, if you had anything to add.

AS: So you can own cash, but having cash is very expensive, because cash is yielding very close to zero, and in some markets actually has negative yield. So, owning cash instead of, let's say, credit, in a credit portfolio can make sense as a buffer. In some cases, owning some cash, but overlaying it with derivative contracts - creating a synthetic bond position - can be another way of building liquidity in a portfolio. What we've found is that most of the derivative indices tend to be the most liquid piece. That's because there is a very large universe of investors that can trade in those.

When you're trading in those derivatives, it's like trading in the S&P 500 index future. You're not making a choice about what name you like, or a particular credit sector, you're just taking market exposure. By doing that, you do reduce by a little bit the amount of alpha generation that you can create in your portfolio, but it actually increases your ability to move your portfolio around in periods of volatility. So it puts you into that alpha that you missed from holding the market basket, it's replaced by being more flexible in moving your portfolio around during periods of redemption.

JU: So you're basically better prepared in case you get redemptions, and you get more flexibility.

AS: You can say in normal times I'm going to own the market basket, but during periods of dislocation, I'm going to move from the market basket into specific sectors or specific dislocated credit, and use that liquidity when it's getting paid for the most.

JU: That makes a lot of sense. One thing I wanted to question was that you advocated taking a broad multi-sector approach so that you can easily move to where liquidity is plentiful. The reason I wanted to bring this up is that we've seen this huge correlation lately. Do you think a multi-sector strategy will really protect your portfolio?

AS: It benefits you in two ways. It allows you to avoid doing dumb things in your portfolio, and it allows you to go after really attractive opportunities. Let me give you examples of both.

If you were investing in 2014 in a U.S. high-yield universe, 30% of new issues that year were in the energy sector. Even if you didn't like energy, you ended up owning a decent amount. That's what was coming and that's what was "cheap" - certainly that was what was cheap by rating.

If you have a multi-sector approach like [AllianceBernstein] did, that year we didn't like the energy stuff that was coming to market, so we bought a lot less of it, or very little of it. What we thought was really interesting was investment grade emerging market bonds were actually trading at levels that single B high-yield was trading at.

Because we had this multi-sector approach, we could simply sit back and say, let's pick the investment grade names in EM that we think are attractive and not buy these energy bonds. And by the way, these EM bonds over the next 6 months ended up being the best performing sector, and high-yield ended up being the worst performing sector. So it allowed us to avoid doing something dumb, and end up doing something that was pretty smart.

JU: That makes a lot of sense. So we've had this big sell off in high-yield - do you think the main trigger for that has been these energy bonds? Is there anything else today that you see that is coming out that isn't attractive but getting decent ratings?

AS: I would say that there are 3 drivers behind it. There was the energy sector, there was the basic materials sector, and more broadly, there was the idea that investors had really reached for yield by going out to triple C issues in the space. If you look at the high-yield market, those areas had been priced for perfection 2 years ago. In at least 2 out of 3, or maybe 3 out of 3, you got an outcome that was the opposite of perfection - You got a major hiccup across all three of those areas.

Now you've repriced to an area where investors are getting a much more attractive risk-return. That's what led us to the lows of earlier this year. I think investors had to shed a lot of risk.

In the meantime, what's been happening to the high-yield opportunity set is you have a lot of fallen angels falling into the space. For anyone that's followed the high-yield market, this is actually a really good thing for high-yield.

If you think about the quality of the index, someone says I want to issue more debt. Debt gets reflected in the index, in the opportunity set. So you end up owning on balance a lot more a lot of that debt that has just been issued. Most people are issuing when it's to their advantage.

When you have fallen angels, that changes the composition of the opportunity set. It makes it attractive to invest in those. Those issuers aren't choosing to issue high-yield, but they are being added to the index because the ratings dropped down. And those companies are trying to improve their balance sheets, maybe even reduce debt, rather than increase debt. We think that's going to shore up a lot of potential return going forward.

JU: Last fall, you described the whole situation as a lot of dry tinder that was waiting for a spark. Do you think that January-February was the big burn, or do you think that there's still a lot of dry tinder out there that is waiting for a new trigger. As a corollary, is there any trigger that you are specifically watching out for?

AS: I think we have seen a pretty good example of a spark and what can happen in the aftermath. In the last couple of the months, you have even seen an esoteric high-yield mutual fund gated its strategy. Granted, it was very unusual. That had a lot of repercussions for the market - one of the most severe short term moves over the last several months.

I think the concepts we talked about continue to be the case. While we have repriced a good portion of the U.S. high-yield market, this applies, more broadly, to a bunch of different markets. We think investors are away of the risks, and they have probably reduced the risks, but for markets where not enough risk is priced in, you can get these additional dislocations. We think that a lot of what has happened has burned out a lot of the initial dry tinder.

JU: So what would you be looking for to know it's time to start jumping in and start taking advantage of these fallen angels? Is there anything specific you are looking for?

AS: It's important for investors to know that fixed income creates its own liquidity through coupon payments and maturities. I think we had, last month, gotten cheap enough that it started getting very, very difficult to actually lose money being long different parts of the credit market.

The reason for that is that you were generating so much income that your breakeven to cash was actually quite attractive. I think that's the kind of framework that people have to use, and say, okay if we just hold this bond portfolio for 12 months or 24 months, what's the likelihood, based on historical price moves, that we actually lose money?

Certainly if you use a 24-month time horizon… we've gotten to a 10% yield on the high-yield benchmark. In 24 months it's really tough, at a 10% yield, to lose, to imagine a scenario where you lose money on that time horizon. It's possible, but given the starting point in valuation, you'd have to see an environment that was more severe than most of the environments we've seen in the past.

That's the type of analysis we want to do to make sure that investing makes sense.

JU: Finally, did you have any other updates, or insights, that have come over the last few months, observing what's been happening.

AS: The other insight I would highlight is that what I was just talking about - the income that comes off the high income portfolio - is an important thing to keep in mind when you are choosing to do your asset allocation between stocks and risk-seeking bonds, like high income. The reason it's important is because, if you go through these volatile periods of time, that income actually cushions you on the downside, and reinvesting that income at high-yields creates return for you, in ways that may not be completely obvious when you go in. These types of high volatility environments are really good for the performance of high income strategies relative to equity strategies.

JU: That's a really good point, and people just following market price action may be missing that part of the picture.

Thanks so much for talking with me, it's been really insightful.

AS: Thank you.

10 Takeaways:

1. Most asset managers have realized the systemic risk resulting from increased regulation of market makers. However to fully appreciate the impact of Dodd-Frank, investors need to take into account the fact that many regulations have yet to be implemented.

2. Retail investors have increased in size in the market as part of a grab for yield, and they are far more likely to buy when prices are high and sell when prices are low - exacerbating huge price swings.

3. Institutional investors are becoming more prone to the same kind of boom-bust dynamic because of VaR-based risk management.

4. The proliferation of risk-parity funds using momentum-based investment styles can exacerbate volatility.

5. Volatility in the Asia region could cause a stress environment where the dollar strengthens. In such a situation, the currency volatility may exacerbate volatility in the bond market.

6. A combination of holding cash and derivatives may be a better strategy to avoid a huge price dislocation in individual bonds, and may provide a way to move into specific bonds that look attractive during a price dislocation.

7. Using multi-sector approaches allows you the flexibility to move into what's attractive at any given time.

8. The quality of the high-yield index has improved, as many higher-grade issuers fell into the index.

9. Take a longer time horizon. If high-yield is paying 10%, price movements over the next two years are unlikely to give investors a negative total return.

10. The income from high-yield bonds can provide a good cushion during highly volatile periods, and give you a chance to reinvest at more favorable prices. That income may make high-yield a better alternative to equities in a period of high volatility.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.