Dipping in and out of credit markets can reduce the value of investments for the non-specialist, but also for more experienced investors.
In their 2014 paper ‘Modelling the Liquidity Premium on Corporate Bonds’, Paul van Loon, Andrew Cairns, Alexander McNeil and Alex Veys of the Actuarial Research Centre at Heriot-Watt University, define the liquidity premium as being “the difference in yield to maturity of a bond relative to the yield on a hypothetical perfectly liquid bond with otherwise identical characteristics. For an investor who is prepared to buy and hold to maturity, the liquidity premium represents the expected reward, per annum, in return for sacrificing the option to sell a bond before maturity. Any investor who plans to or might need to sell before maturity will, on average, earn a lower premium than our estimate.”
For buy-side traders who work in emerging markets, high yield, and other more niche, less liquid areas of credit, the liquidity premium is a aspect of the investment process.
“The onshore corporate bond market in China is a benchmark for global investors and it’s a very illiquid market,” notes one senior EM trader. “On a day with three big bond offerings one of those might not trade at all, and that’s not uncommon with onshore Chinese corporate bonds. In US or EU credit, a bond gets issued, and usually that’s one of the most active days. On onshore CMI corporate bonds are a very illiquid market.”
Where markets are harder to trade or invest in directly that naturally limits the amount of non-local trading, and that can be quite different in credit to government bonds.
“Offshore ownership of the Chinese credit market would be the low single digits and unlikely to change,” notes one trader. “It’s a very different situation for government bonds and macro/rates products in those markets where there is significant offshore participation, particularly for indexed markets.”
The reward for accessing these harder to reach credit markets is that liquidity premium, However this can be undermined if non-specialist firms begin to trade in the space, the so-called ‘tourist’ investor.
Any misunderstanding of the pricing in a market can reduce the premium being paid for by the ‘tourist’ investor, but the impact will also be felt by specialists.
“Where we get tourists in the EM space, their negotiations for new issues can see the primary premia eroded for all potential buyers, while the potential for a portfolio to turn over the bond reducing their liquidity premia also decreases the value of the investment,” notes one portfolio manager.
While academic studies have found that investors with shorter expected holding periods typically hold more liquid assets and investors with longer expected holding periods hold illiquid assets, in practice funds may cross that line in the search for yield can damage the value seen by investors.
With rates expected to fall in 2025, it is worth investors being cognisant of the pre-trade pricing they are using to ensure their getting the best outcome for their investors.
©Markets Media Europe 2024
