New Credit Market Liquidity Regime Requires Action

Defined benefit (DB) plan sponsors are credit investors; they have investments in Treasury bonds and investment grade corporate bonds, and they may also invest in direct lending. Liquidity can be a concern when there is an asset/liability mismatch in commingled vehicles, and there is a risk that funds may sell illiquid assets to meet redemption requests.

Thierry Adant, a consultant for credit research at Willis Towers Watson in New York City, tells PLANSPONSOR there is a new market liquidity regime, in part due to banks no longer being in the business of holding an “inventory” of credit bonds to match redemption demand. DB plan sponsors should act to protect themselves in the new regime, and in some cases, they can even capitalize from it.

A Willis Towers Watson paper, “Credit Market Liquidity,” says in the new banking regulatory regime, banks have significantly decreased their stock of credit bonds since regulators have made it much more expensive for them to hold such an inventory. The result was that in 2015, inventory in corporate bonds averaged less than one day’s trading volume in corporate bonds, with inventory roughly 25% versus peak levels. “In our view, credit market liquidity has deteriorated as a consequence of the new regulatory regime,” the paper says.

The firm is concerned that the supply of liquidity is no longer capable of satiating demand, which will become obvious during periods of market stress, when investors often seek to reposition.

According to Adant, this has been seen already a couple of times in the market—the two worst episodes were the 2013 “Taper Tantrum” and the October 2014 U.S. Treasury “flash crash”—but Adant thinks it is more prevalent. “There are broader implications of asset/liability mismatch,” he says. “If [a DB plan sponsor’s investment] strategy requires a high level of turnover, there will be less returns because liquidity is more expensive.”

He notes that liquidity risks are on the agenda of regulators. For example, in the mutual fund space, the Securities and Exchange Commission (SEC) has proposed a set of reforms about open-end funds’ liquidity management programs.

Adant says DB plan sponsors should assess whether they are in the right vehicle structures or funds offering the right liquidity terms. Certain strategies may not be workable. “The best example is credit long/short or hedge fund type strategies,” he says, adding that the number of bonds that trade actively and can execute an effective strategy has diminished, so plan sponsors may not have many options in facilitating trades.

The Willis Towers Watson paper also suggests plan sponsors review the liquidity and fund terms of all the commingled products in which they invest. “Indeed, we strongly believe that an evolution in commingled fund liquidity terms would serve to reduce the risks associated with the new credit market liquidity regime,” it says. Plan sponsors should negotiate for better terms, or shift to products that are better structured where possible.

Other suggestions include monitoring cash in commingled investment funds. Commingled funds will run with higher cash balances to reflect the new liquidity regime, which will create a drag on performance. Plan sponsors should seek to renegotiate investment management fees down accordingly.      

The paper suggests plan sponsors budget for higher volatility and higher trading costs in their portfolios. “Almost all investment managers profess a willingness to act as a ‘supplier of liquidity’ to replace the investment banks. In reality, this is incredibly challenging given the difficulty of forecasting these episodic periods of high volatility and constraints around expanding balance sheets in order to exploit market weakness,” it says.

Despite the risks, Adant says there is still an excess return to be had. There are a number of opportunities plan sponsors should consider as part of tactical as well as strategic asset allocation. For example, according to the Willis Towers Watson paper, it is expected that the illiquidity risk premium will be, on average, higher to compensate for investors under the new regime. “This presents an opportunity for institutional investors with a long investment horizon to be able to ‘lock up’ their capital and generate higher returns,” the paper says.