The realization that there is, as of this moment, at best negligible and very often zero liquidity in bonds (or even stocks) is known by most: a topic we first discussed back in the summer of 2013 (a good place to start is Phantom Markets: Why The TBAC Is Suddenly Very Worried About Market Liquidity) has become so pervasive that even the BIS admitted last week bond market liquidity has cratered, with some estimates suggesting that corporate bond liquidity is down 90% since Lehman, mostly thanks to central banks' unprecedented absorption of some $5 trillion in "high quality collateral" from the private market.
In fact, moments ago the head of the Bank of England himself, Mark Carney, warned about the risk of "disorderly unwinding of portfolios" due to the lack of market liquidity.
"Market adjustments to date have occurred without significant stress. However the risk of a sharp and disorderly reversal remains given the compressed credit and liquidity risk premia," Carney told a news conference after a meeting of the FSB.
"As a result, market participants need to be mindful of the risks of diminished market liquidity, asset price discontinuities and contagion across asset markets."
Liquidity, which is increasingly synonymous with the inverse of Fed counterparty risk because in a world in which the Fed has onboarded virtually all risk, there is no need for market-making since only buying is encouraged and any concentrated selling leads to an immediate market break, has become such a buzzword, it is the topic of Howard Marks' latest letter.
We will skip the big picture of Marks' observations on how we have reached this sad state and what will eventually happen in a market devoid of liquidity, as most of it has been covered before, but we will focus on what Howard Marks thinks will happen in a far more murky and misunderstood aspect of modern markets: the synthesis between ETFs and underlying securities. Because while nobody doubts that liquidity in underlying cash instruments has rarely been worse, this is offset by substantially better liquidity in the ETF space if only superficially, thereby allowing amateur "analysts" to disregard the reality of systemic liquidity shortages and focus on what the red pill reveals: why, just look at how liquid the JNK is.
Well, no. This is what Howard Marks thinks about ETFs and the phantom liquidity impression they create. For the impatient ones, here is a spoiler alert: think Auction Rate Securities.
ETF-like vehicles, sometimes known as “tracking shares,” began to appear in the early 1990s, and they proliferated significantly after 2000. According to Wikipedia, “As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.” (Several years ago I cited Wikipedia in a memo, and Oaktree co-founder Richard Masson – a stickler for correctness – told me in no uncertain terms that it wasn’t a respectable source. I think things have changed enough since then, Richard: I’m citing it!)
ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity?
Here’s what Wikipedia has to say about the liquidity of ETFs:
An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. . . .
Consider the possibility that many of the holders of an ETF become highly motivated to either buy or sell. Their actions theoretically could cause the trading price of the ETF to diverge from the value of the securities in the underlying portfolio. To minimize that risk, the creators of ETFs established a mechanism through which financial institutions can trade in wholesale quantities of “creation units” of the fund at NAV.
What would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once? In theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to minimize the potential deviation between the market price and the net asset value of ETF shares. Existing ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets they must assemble if they wish to purchase a creation unit, and the exchange disseminates the updated net asset value of the shares throughout the trading day, typically at 15-second intervals.
If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value.
This whole discussion calls to mind a Wall Street Wonder called “auction rate securities.” They were popular ten years ago, but today they’re only a footnote to financial history. In brief, auction rate securities were developed to satisfy the desire of borrowers for long-term financing at the lower interest rates on short-term debt. The securities were described as safe and liquid because Dutch auctions would be held every week or month, resetting the yield on the securities to contemporary levels and thereby ensuring a price near par, as well as plentiful liquidity. Certainly there would always be some yield capable of enticing investors to buy at par. Thus the securities would be free from the risks associated with long-term debt. That’s what should have happened. Here’s what Wikipedia says did happen:
Beginning on Thursday, February 7, 2008, auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combined with the firms’ needs to protect their capital during the 2008 financial crisis. (Emphasis added)
On February 13, 2008, 80% of auctions failed. On February 20, 62% failed (395 out of 641 auctions) . . . .
When the auctions failed, auction rate securities became frozen. Holders saw large markdowns and for years were unable to obtain liquidity. Eventually, the investment banks that had issued the securities bought many of them back at par, under threat of investigation by U.S. attorneys general. And one more “miracle” disappeared from the scene.
Lastly on the subject of ETFs, a senior loan ETF can be sold for settlement in three days, whereas if there are tenders of creation units, sales of loans to raise the funds with which to pay for those units may require a week or considerably more to settle. What are the implications of such a mismatch?
So-called “liquid alternatives” or “liquid alts” are another recent innovation. They’re supposed to deliver performance comparable to other alternative investments without the illiquidity they entail. To me it sounds like just one more promise of something for nothing. How many portfolio managers are smart enough, for example, to deliver the alpha of a well-managed hedge fund without accepting the illiquidity that the clever manager of that hedge fund feels he has no choice but to bear?
Financial innovations created in good times often fool people into thinking a silver bullet has been invented that offers a better deal than traditional investments. (By “traditional” I mean investments that are acknowledged to entail increased risk as the price for targeting increased return . . . not the “miracles” where increased return comes gratis.) Many recent innovations have promised high liquidity from low-liquidity assets. As I said on page three, however, no investment vehicle should promise more liquidity than is afforded by its underlying assets. Do these recent promises represent real improvements, or merely the seeds for subsequent disappointment?
Auction rate securities were a way to buy long-term debt securities without interest-rate risk and illiquidity. Likewise, ETFs offer a liquid way to invest in potentially illiquid markets. But these instruments rely for their desirable outcomes on the assumption that other parties will do what they “should” do. Over the course of my career I’ve seen many instances when market participants failed to do what they were supposed to do. The related financial innovations often remind me of my father’s story about the habitual gambler who finally found a sure thing: a race with only one horse. He bet all his money, but halfway around the track the horse jumped over the fence and ran away. Will ETFs prove liquid in the next crisis? And what impact will mass sales of ETFs have on the prices of underlying assets? We’ll find out.
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For the last few years I’ve been expressing my view that (a) investors – driven by central bank-mandated interest rates near zero – have been moving into riskier investments in pursuit of higher returns and (b) in taking that step they’ve often ignored the need for caution or been ignorant as to how to achieve it. I believe that as an important part of this behavior, those investors have extrapolated the high level of liquidity they’ve witnessed in the last five years, failing to understand its transitory nature.
The impact on liquidity of ETFs, liquid alternatives and the Volcker Rule has yet to be tested in tough times. We’ll see what happens in the next serious downturn.
We will, but we can all make some educated guesses.
Before we let readers read the full must-read Oaktree note on their own, he, too, will end with Marks' conclusion because indeed, it lays out the endgame for the central banks, who have onboarded some 7 years of market risk on their balance sheet with inevitably tragic consequences, quite well:
I started this memo by saying liquidity might not be a profound topic. But when I ran a draft by our CEO Jay Wintrob, who came to us in November from AIG, he took issue. I’ll give him the last word:
In September 2008, AIG experienced serious liquidity issues (despite its $1 trillion balance sheet) when it couldn’t post $20-25 billion of liquid collateral related to credit default swap contracts written by one of its subsidiaries. The U.S. government stepped in as a result, lending support that eventually reached $182.3 billion, massively diluting AIG shareholders in the process. When you can’t meet a margin call because you have insufficient liquidity, that’s profound.
Already seen at the SNB, soon coming to all major central banks near you (pdf).