Liquidity is often treated as a constant in public markets, something investors can rely on. Recent events suggest a more complex reality. Many current concerns around credit are focused on private credit – and that conversation is worth having – but for investors in public fixed income, the more relevant question is: do you really understand the liquidity profile of what you hold?
How liquidity behaves under stress
Liquidity is associated with volatility. Assets that move more in price are perceived as riskier, while those that appear stable are seen as defensive. But in stressed markets, that relationship can invert. Liquidity is what allows prices to adjust. It enables investors to reduce exposures, reposition portfolios or take advantage of dislocations.
The consequence is that in the early stages of a sell-off, liquid credit can appear to underperform. This is because most liquid holdings are easiest to sell when outflows rise.
But investors watching these positions get marked down while less liquid holdings remain at book value may come to the wrong conclusion. Far from holding their value, those bonds have simply not been tested yet.
The real stress comes later, when outflows become sustained. At that point, managers are forced to sell further down the liquidity spectrum and assets that looked stable begin to reprice, sharply, with limited buyers.
Private credit markets have experienced this in recent months, with redemption requests exceeding quarterly liquidity windows at several semi-liquid vehicles after AI concerns hit software-heavy portfolios.
Public credit has enjoyed inflows for an extended period. The past few weeks have shown early signs of a reversal. If that is sustained, the sequencing described above could play out here.
Where liquidity risk actually sits
Not all public credit securities carry the same liquidity profile. New issues are among the most liquid instruments in the market – actively traded at launch and attracting broad investor bases. That liquidity is also what makes them the first to be sold.
In recent weeks, pressure in public credit has come disproportionately through the new issue side, with airlines and other economically sensitive sectors seeing sharp underperformance.
At the other end of the spectrum sit instruments that look liquid on paper but are not in reality. AT1 bank bonds are a case in point. Widely held and exchange-listed, they rank equally with equity in the capital structure. But in an extreme stress scenario, if the equity is worthless, the AT1 bonds are too.
Similarly, the lowest-rated high yield bonds carry refinancing risk that could become a real problem in challenging markets. Over $60bn of CCC/C-rated high yield bonds mature this year – more than double the equivalent figure for single-B debt.
Secondary prices for CCC/C issuers have already dipped well below par. When those bonds need to be refinanced, much will depend on where spreads are and whether buyers are willing to step in.
What active liquidity management looks like
If liquidity is uneven across different instruments, it follows that not all credit portfolios carry the same liquidity profile. For investors fearing a period of prolonged market stress, the rigour of their fund manager’s liquidity management should be an important consideration.
The scale and breadth of the $145trn public bond market – spanning sovereign and corporate issuers across multiple currencies, maturities and credit ratings, with average daily trading volumes exceeding $1.5trn – allows for genuine active management. But that requires holding assets that can be sold when needed.
Recent weeks have illustrated the dispersion stress creates. Defensive sectors such as utilities have been relatively resilient; more cyclical areas including airlines have come under pressure.
Uncertainty about growth and geopolitical stress – including the Iran conflict's knock-on effects on energy prices, government bonds and emerging markets – is adding to volatility. In that environment, a manager’s ability to act is critical.
Understand what you own
The quality of the investment grade and high yield universe has improved in recent years. Almost 60% of US high yield issuers are now rated BB, the highest proportion on record. But it does not mean all credit is equally liquid or that all credit managers manage liquidity with equal discipline.
Investors evaluating credit funds should look beyond the average yield and credit rating of the portfolio and consider what the liquidity profile might look like under stress. A short-dated credit fund with a concentrated investor base and significant exposure to illiquid instruments should not be assessed on the same basis as one with more conservative construction, even if both carry the same risk label.
During sell-offs, even high-quality bonds get marked down alongside everything else. This creates opportunity for active managers. As investors assess their allocations at this stage of the cycle, their focus may need to shift from chasing yield to understanding how it is delivered and what trade-offs it entails.
Because when conditions change, the ability of their fund manager to act matters just as much as the returns they provide.
Alex Ralph is co-portfolio manager of the Global Strategic Bond fund at Nedgroup Investments. The views expressed above should not be taken as investment advice.