Low Liquidity? Time For Traders To Dig Deep by Douglas J. Peebles, Ashish Shah, AllianceBernstein
Sometimes it seems like bond market liquidity dried up overnight. It didn’t. We read the writing on the wall years ago and revamped our trading desk to deal with the potential fallout. Some managers are still playing catch up.
Trading expertise has always been important for large investment management firms. But the trader’s job description has changed. In the past, when portfolio managers placed orders, the trader’s main job was to get the best price possible.
That isn’t enough anymore, because several trends that developed in the aftermath of the global financial crisis have made bond markets less liquid. Traders today have to know what the price of a bond should be, depending on how liquid the market is.
In other words, traders help us determine whether to buy or sell a security, and provide valuable insight about when and how to do it. This judgment is critical, since liquidity conditions can have a big effect on security prices and availability.
Making Liquidity Risk a Central Concern
We saw this shift coming more than four years ago. To prepare, we brought in traders with expertise in pricing liquidity—many with backgrounds at hedge funds and big sell-side banks.
We also created a global team of traders dedicated exclusively to corporate credit, each focused on specific industries.
Perhaps most important, we’ve ensured that our traders play a central role in every portfolio decision. Now that liquidity risk is as important as interest-rate and credit risk, we can’t imagine doing it any other way.
Becoming a Liquidity Provider
When liquidity is shallow, traders have to dig a lot deeper to find opportunities. They also have to be agile enough to take advantage of them.
As our colleague Gershon Distenfeld writes, low liquidity has led to exaggerated sell-offs in many credit assets. That creates potential opportunities for investors who have built liquidity buffers into their portfolios.
But it takes a skilled trader to make the most of these and other liquidity-driven dislocations by being a provider of liquidity when others need it. Think of the traders who used the 2013 taper tantrum or this summer’s downturn in credit to buy attractive bonds when everyone else was hitting the sell button. For providing liquidity when others needed it, they were compensated with higher yields.
Big investment banks and primary dealers used to play the liquidity provider role. But new regulations have forced them to scale back their bond-trading activities, leaving it up to the buy-side traders to sniff out alternative sources of liquidity and move swiftly to take advantage of those wellsprings.
Here are some things our traders do to help us manage liquidity risk:
Provide intelligence on market conditions. By tapping into their extensive network of market contacts, our traders keep portfolio managers abreast of what securities are available in a given industry at a given time. Traders routinely advise managers about liquidity levels and the potential market impact that a purchase or sale is likely to have.
Proactively locate sources of liquidity. Instead of waiting for a security to come up for sale, our trading staff regularly inquires with a vast array of brokers about specific types of securities or deal structures that we want for our clients’ portfolios.
Sometimes, counterparties find the bonds in question. Other times, our traders use derivatives to give us exposure to synthetic securities, allowing us access to additional pools of liquidity and potentially reducing transaction costs.
Invest in new technologies. Over time, more electronic, all-to-all trading platforms that can match large orders among a bigger pool of buyers and sellers may help address market liquidity. We’ve met with multiple electronic trading start-ups and are devising ways to enhance our own quantitative tools.
Some asset managers are only now coming around to the need to integrate traders fully into the investment process. Before entrusting money to anyone, investors should find out how prospective managers view traders’ roles and how big a part traders play in the firm’s overall fixed-income strategy.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.