Liquidity Premiums Creating Risks and Opportunities in Fixed Income

Transcription

1 Liquidity Premiums Creating Risks and Opportunities in Fixed Income Regulatory Changes in Global Bond Markets Leading to Unintended Consequences That Can Benefit Savvy Long-Term Investors (Pasadena, Calif, November 30, 2015) In his webcast, Understanding, Managing and Capitalizing on Bond Market Liquidity, Western Asset Management Deputy Chief Investment Officer Michael C. Buchanan declared that the elevated concerns surrounding liquidity conditions are justified, and we don't see these conditions changing anytime soon. The decline in liquidity we have seen has certainly made markets less efficient, Mr. Buchanan said. Because of this inefficiency, securities often have departed further from their intrinsic value, thereby creating great opportunities for value-oriented investors like Western Asset. We think the decline and bond market liquidity is multi-faceted. It's the cause of secular forces, and we don't see those forces going away. To manage this illiquidity, you do have to have very deep integration and coordination with your risk management effort. It's important to note that it has created opportunities for value-oriented investors we certainly are taking advantage of. A replay of the full 29:11 podcast can be assessed here: By secular, Mr. Buchanan said many of the forces changing liquidity conditions stem from regulatory changes, such as Dodd-Frank and Basel III, and the ongoing evolution of brokerdealer practices. While the overall market has grown by nearly a third, dealer holdings have declined from five percent of U.S. corporate credit asset ownership in 2005 to one percent in Dealer inventories are designed to facilitate an orderly flow of markets and really compliment their capital markets efforts, Mr. Buchanan explained. They are a source of risk capital that's in the market every day, making bids and offers on an array of different securities. When you reduce that, it does have a real negative impact on liquidity. That's clearly what we're seeing. Mr. Buchanan stressed that fixed income investors considering liquidity should bring this back to some of your strategies looking at premiums, making sure you're getting paid more than your fair share for less liquid investments. This also requires that investors manage the increased volatility that's going to be coming and has come with this less liquid environment. Ultimately, liquidity impacts investors obviously through higher volatility, he said. Also, through a higher illiquidity premium. And in a worst case scenario, a real inability to trade. None of this analysis is new to Mr. Buchanan and the Western Asset team. We've always looked at liquidity as one aspect of proper spread over the risk-free rate for making an investment, and that's true for corporate securities and non-corporate securities, he said. We have always factored in liquidity. Now there is a much greater awareness of this

2 liquidity or, probably better said, lack of liquidity. So as much as we're having a discussion on the fundamental specifics of a particular issue or issuer, we're also talking much more with our traders about understanding the liquidity profile of that security, and making a real cognizant decision about how much we need to get paid to compensate us for that illiquidity. That illiquidity premium is growing. It does benefit investors who don't necessarily go into corporate credit or fixed income in general with the idea that I'm going to make a lot of money actively trading it. It really benefits investors that take a longer term, fundamental view. In his remarks and answers to questions, Mr. Buchanan promoted a hands-on, active approach. This is a real unique opportunity that, through superior fundamental research, we can continue to identify companies that have great management teams, great business profiles and prospects, and ultimately get paid more for those particular issues, he said. We're demanding a greater illiquidity premium, but we're still getting the same kind of investments. A long term investor is going to make more throughout the investment life of a security than they otherwise would as a benefit of that illiquidity premium. We also have been using derivatives more frequently to manage the volatility in our portfolios. The Western Asset Management team understands there are drawbacks to these approaches. The more you're using derivatives, you are obviously giving up alpha, Mr. Buchanan explained. It puts greater demands on a firm s overall risk management process, but we've found that an integrated and mixed approach between these two tends to work best. It really gives our clients what we feel is the most attractive risk-reward relationship for their portfolios. As for whether risk management precautions taken to manage liquidity risk might hamper returns, despite higher liquidity premiums, Mr. Buchanan stressed, Risk management acts to dampen volatility. We're seeing that in our portfolios. They are less volatile during times of stress. Now, taken to an extreme, if we went through a market that was an extreme risk-on and hitting on all cylinders, yes, not having some risk management overlay you could argue would release the portfolio to achieve a very, very high level of return. But we think sacrificing some of that upside is worth it in terms of dampening the overall volatility and protecting our investors during periods of stress and fundamental deterioration. Risk management is essential. If we did not learn that from the crisis, then shame on us. Asked whether the illiquidity dynamic is impacting markets outside the U.S., Mr. Buchanan said: It is a global phenomenon. We have seven investment management offices globally. We're constantly talking with our colleagues and in some way, shape or form, we're all experiencing the same thing. You are seeing a reduction in liquidity. It's affecting different markets differently, but directionally, post-crisis it s pointed toward deterioration or worsening liquidity. In terms of sectors that may be benefiting from lower liquidity, Mr. Buchanan singled out banks.

3 Because of the regulatory scrutiny, banks and financial institutions are clearly benefitting, he said. The whole mechanism behind a lot of this regulation is to make them fundamentally stronger and safer. It improved capitalization, reduced leverage. In our positioning at Western Asset, we thought these regulatory forces were real. They were causing banks to behave more like utilities as opposed to perhaps casinos, that they were pre-crisis. Our clients have benefitted from this secular trade of stronger fundamental improvement. The high yield energy sector provides a good example of how bond spreads have been impacted. There has been a dramatic widening of high yield energy bonds versus the overall high yield index, Mr. Buchanan reported. Some is due to fundamentals, as the dramatic drop in crude oil has caused real stress at a lot of issuers; however, we believe illiquidity has also contributed. Although it's difficult to measure exactly how much is due to fundamentals, or to technical issues or liquidity issues, through research and coordination with our traders, we believe in this particular instance, illiquidity is responsible for at least 150 to 200 basis points of the widening. The Western Asset Management team believes the ability to transact fixed income has changed post-financial Crisis primarily from financial regulation. In the U.S., Dodd-Frank limits broker dealers from engaging in proprietary trading and limits their ability to invest in hedge funds and private equity. In Europe BASAL III is focused on improving the capital strength of financial institutions through reduced leverage. This is increasing capital charges for dealers' inventory. What's not as well talked about is changing behaviors, if you think about the severity of the crisis in 2008, Mr. Buchanan observed. That really has taken a toll on risk profiles. It's elevated risk awareness. Risk spirits are damaged and there's less opportunistic capital being deployed in markets. In periods of volatility, that's manifesting itself in less liquidity. In addressing the subject, Mr. Buchanan was careful to explain what he meant by liquidity. We all realize what liquidity is, or at least intuitively realize, it's really the ability to transact within a reasonable time period, within a reasonable bid ask spread, he said. Two ends of the spectrum would be trading highlighted in Michael Lewis's book, Flash Boys: high frequency trading, where multiple trades happen within fractions of a second. The other end could be commercial real estate, residential real estate, which trades once every 5 to 10 years. Liquidity does change over time, Mr. Buchanan said. In times of market stress, liquidity becomes more challenged. As markets develop, liquidity tends to develop with those markets. Some nuances affecting liquidity aren't so obvious, but have been with us for a long time, he said. In corporate credit, think about the liquidity differential between large versus small issues. Consumer non-cyclicals tend to be more liquid than deeply cyclical credits. Rating tends to affect liquidity profile: higher rated securities tend to be a little more liquid. Also underwriters: if it's a sole underwritten deal, it tends to be less liquid than with numerous underwriters. ######################

4 About Michael C. Buchanan CFA Deputy Chief Investment Officer of Western Asset Management Mike Buchanan is a specialist in high yield, as former head of the Global Credit team. Prior to joining the firm in 2005, Buchanan served as managing director and head of U.S. Credit Products at Credit Suisse Asset Management, and as executive vice president and portfolio manager at Janus Capital Management. He also worked at BlackRock Financial Management as a managing director and portfolio manager, and at Conseco Capital Management as a vice president and portfolio manager. A Certified Financial Analyst, Buchanan earned his B.A. from Brown University. About Western Asset Management Western Asset Management is a global leader in fixed-income management with $455 billion in assets under management as of March 31, The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. From offices in Pasadena, Hong Kong, London, Melbourne, New York, São Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. To learn more about Western Asset Management, please visit About Legg Mason Legg Mason is a global asset management firm with $697 billion in assets under management as of October 31, The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM). DEFINITIONS Alpha A measure of performance vs. a benchmark on a risk-adjusted basis. An alpha of +1.0 means the portfolio has outperformed its benchmark index by 1%. An alpha of -1.0 means it has underperformed its benchmark by 1%. Basis Point A basis point is one one-hundredth of one percent (1/100% or 0.01%). All investments involve risk, including loss of principal. Past performance is no guarantee of future results. Investments in fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. An increase in interest rates will reduce the value of fixed income securities. Derivatives, such as options and futures, which can be illiquid, may disproportionately increase losses, and have a potentially large impact on performance. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Risks of high-yield securities include greater price volatility, illiquidity and possibility of default. Potential active and frequent trading may result in higher transaction costs and increased investor liability. Diversification does not assure a profit or protect against market loss. The views expressed are as of the date indicated, are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Securities and sectors referenced

5 should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE 2015 Legg Mason Investor Services, LLC, member FINRA, SIPC. Western Asset Management Company and LMIS are subsidiaries of Legg Mason, Inc.