Imagine you wanted to sell your investments. Do you know how much time it would take? And would you get an acceptable price?
At issue here is a feature of markets known as “liquidity.” We may not think about it often, but the lack of it can be costly. For example, if you wanted to sell an investment quickly during an emergency or market drop, you might have to slash the price to attract a buyer. In a crisis, liquidity can disappear altogether, making an investment impossible to sell at any price.
“Liquidity is something most people don’t think about until it’s too late: It generally becomes an issue only when you can’t get it,” says Tony Davidow, Alternative Beta & Asset Allocation Strategist Asset Allocation Strategist at the Schwab Center for Financial Research. “Many investors earmark highly liquid funds (like cash) for a rainy day, but it’s also a good idea to have some kind of exit strategy for your investments.”
While many investors look to bonds for capital preservation and income, the bond market isn’t as liquid as it used to be. Here we’ll look at some regulatory changes that have impacted the bond market and what you can do to help manage potential problems.
Changes in the bond market
Structural changes since the 2008 financial crisis have made lower-grade bonds more difficult to sell. This may mean investors’ fixed income portfolios aren’t as liquid as they might expect.
In the stock market, securities generally trade on centralized exchanges that bring together many buyers and sellers, and where price changes are posted immediately for all participants to see. In contrast, many bonds trade in decentralized “over-the-counter” markets, where dealers or banks help arrange trades between individual buyers and sellers. And it can take time for price changes to become public, so traders may not know what a bond is “worth” until after someone has bought or sold one.
In the past, if dealers couldn’t find a buyer right away, they would often just buy the bond itself and keep it on their own books. This helped make bond markets more liquid. Sellers could cash out more or less when they wanted, and buyers could generally find a ready supply of bonds on dealers’ books.
However, that practice changed after the financial crisis. Banks and dealers are now less willing to add lower-grade bonds to their inventories for two reasons: regulatory changes require them to take less risk, and a potential interest-rate increase could cause many bonds to lose value or become difficult to sell. Overall, the retreat of dealers from their traditional role in facilitating trades has tended to make the bond market less liquid.
The risk here is that in a volatile market, where eager sellers far outnumber willing buyers, prices can change quickly. For example, if only a few trades are done at distressed prices as investors try to offload bonds in a market with few buyers, prices across the market can drop sharply.
Fixed income funds
Bond dealers’ newly conservative stance has coincided with soaring demand from individual investors. Since 2009, more than $1.1 trillion has flowed into bond funds, much of it into the riskiest, least-liquid sectors of the market: More than 10% has flowed into high-yield bond and bank loan funds.1
Such funds could see their prices swing if the underlying bonds become volatile because of liquidity problems.
“If too many investors try to exit their bonds, bond funds or exchange-traded funds (ETFs) at the same time, it will either become difficult for investors to get a reasonable price on the bond they’re looking to sell, or clog up the bond market’s pipes altogether and cause a steep drop in prices,” says Kathy Jones, Chief Fixed Income Strategist at the Schwab Center for Financial Research.
This might come as a surprise to investors who assume that because ETFs trade intraday, like a stock, they are immune to the liquidity constraints inherent to certain parts of the fixed income market. But as Tony explains, an ETF is only as liquid as the underlying constituents.
What can investors do?
This isn’t to say less-liquid assets have no place in an investment portfolio. Indeed, some fairly common assets can be difficult to sell—and tend to offer higher yields in exchange for that risk. And if you can avoid being in a position in which you are forced to sell assets in a volatile market, a bout of illiquidity may not affect your portfolio. The takeaway for investors is to know exactly what’s in their portfolios and what sort of liquidity risks are associated with those assets.
Here are a few ways to prepare for potential liquidity issues:
Take liquidity into consideration when you invest.Treasury securities and some large-cap stocks are generally among the most liquid securities. Among bonds, investment-grade corporate bonds tend to be more liquid than sub-investment-grade (or high-yield) corporate bonds. Municipal bonds, bank loans and other smaller markets tend to be among the least liquid. The size of the individual issue will also affect the liquidity of the individual bond. Larger issues tend to have greater liquidity than smaller issues—especially in municipal bonds.
Focus on your time horizon.If you are a buy-and-hold investor, or have a long-term horizon, then you may be willing to ride out temporary bouts of volatility. However, if you need to access your money in the short term, cash or cash-like investments are more appropriate.
Try to avoid selling during major market events.Understand the level of volatility you are willing to bear so you’re prepared when a market event occurs. In the past, such events have lasted several days. If you don’t have to sell during that time period, and you don’t panic and rush for the exits, you may find that pricing becomes more rational after the market calms down.
Consider limit orders for ETFs (particularly fixed income ETFs).These are orders to buy or sell at a set price (the limit) or better. Investors concerned about shocks can set “marketable limit orders,” where the limit price is at or close to the best bid or best ask. Specifying the price at which you are willing to buy or sell an ETF does not guarantee execution, but it does protect you from executing a trade at a disagreeable price.
Mind your trading times.Markets tend to be more volatile at open and after hours, so it’s best to avoid placing any sell market orders during this time.
1 Morningstar Inc. data on monthly asset flows from 01/2009 to 05/2016.