Latest G10 Macro Rates Blog
With Shayne Dunlap, Co-Portfolio Manager
When is daily liquidity not daily liquidity?
Easy, when the fund is gated, or more technically when there is a mismatch between the liquidity of the wrapper (daily UCITS etc) and the less liquid underlying investments.
Are we seeing the recent gating of some high-profile funds, as the first major casualties of a Great Liquidity Trap?
The true effectiveness of QE and its side effects will not be known for many years to come. However, the asset price inflation seen post GFC coincided with vast sums of money invested by central banks globally into sovereign bonds, and in some cases corporate bonds and equities. We believe this process spurred the immense growth of VC and PE funds, it accelerated the wealth divide, and started a “grab for yield” arms race. This forced many investors into longer maturities and further out the credit spectrum, into less liquid sectors where they weren’t natural inhabitants of these specialty asset-classes. Whilst yields continued to fall and credit spreads narrowed, “all was fine”. For example, buying the 100-year Austrian government bond late last year would have made you nearly a 50% return, based on its 70bp rally to this June. The problem with $12.5trn of the worlds bonds negatively yielding, (Denmark is about to join Switzerland with its entire sovereign curve below zero), is what happens when the music stops? How do the traditional investment community achieve positive returns if yields no longer keep rallying at the same pace?
The rally in the US 10-year treasury bond since 1981, has given the market a false sense of security. Successive central banks have provided free equity “puts “in some way, shape or form. The last 38 years has provided a generation of market participants who have experienced nothing but a continual performance of bonds, and excluding a few blips, credit and equities too. This is not a healthy backdrop to any meaningful market upheaval. The criteria of daily liquidity must now be viewed as having been compromised and as recent market events are now showing that this liquidity cannot be met in all scenarios. It would be wise to remember the initial exposed entities and funds, New Century (April 2007) and the two BNP Paribas subprime funds (August 2007), floundered more than a year before the demise of Lehman Brothers.
Back then, the CDO market that caused so much pain during the GFC had grown from $20bn Q1 2004 to $180bn Q1 2007, think now CLO’s, the riskier packages of loan originators books. CLO issuance has hit $8.4bn for 2019, on course to eclipse 2018 $13.9bn total, and in turn already above 2017’s $7bn of deals.
The rapid growth of these illiquid products hints at a potentially similar mispricing of liquidity. In 2008, mortgage risks were underestimated by almost all institutions in the chain from originator to investor by underweighting the possibility of a synchronised falling housing prices based on historical trends of the past 50 years. Limitations of default and prepayment assumptions, the heart of pricing models, led to overvaluation of mortgage and asset-backed products and their derivatives by originators, securitizers, broker-dealers, rating-agencies, insurance underwriters and most investors. Now we have a market that is reliant on the liquidity models of old, which assumes that demand on a market retracement will behave as it has in the past. Many of these assets such as CLO’s, private illiquid bonds or equities issued to finance commercial ventures have found their way into the likes of mainstream funds offering daily liquidity.
In past market breakdowns, large banks would soak up excessive moves and dampen volatility. Today, big bank balance sheets to warehouse risk are no longer desired by regulators or are part of the banks’ new business models. This means bank market making liquidity has shrunk to the point that it will not take too many “hot potato” positions being passed around to create a vicious downward spiral on prices. Distress funds and hedge funds will ultimately step in, but only after significant losses have been realised.
The hunt to investigate many open-ended funds and see exactly what’s inside, has just started in earnest. Why would an investment manager take the career risk of not taking a closer look?
Be prepared for more gating headlines picking up over summer. (Another notoriously illiquid trading period btw).
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