Very few people actually understand liquidity in credit (or non-government bond) markets. Many express opinions on the subject of credit liquidity and, for example, the lack thereof in March 2020, but they tend not to be actual traders of liquid assets. 

They are almost always observers (ie, non-participants) or investors in illiquid credit. And investors who in 2020 queried the lack of liquidity in credit markets almost always thought they were holding liquid assets when any serious study of those bonds would have revealed them to be illiquid during stressful market conditions. 

One of the reasons Coolabah is so unusually transparent about our trading activity is to inform the public about the true nature of the accessible underlying liquidity in credit markets, which are inherently very opaque given they are over-the-counter (or unlisted) and because ASX/Austraclear, which is the central clearing-house for all OTC bond trades, steadfastly refuses to publicly release the data they capture on daily trading activity and price changes. (We have requested they do this for years, but to no avail thus far.)

Coolabah's empirical research shows that there is an extremely strong relationship between credit quality (or the risk of default) and liquidity, by which we mean the ability to transact (or buy and sell) an asset while minimising market impact costs in all market conditions. Another dimension is of course tradeability. It is possible to have very safe assets, like a term deposit, that are not tradeable. In the case of TDs there is a minimum 31 day holding period that is imposed on investors that results in a period of blanket illiquidity. A further example might be a safe and secure loan, which cannot, however, be easily traded in a secondary market.

In the video interview with Pinnacle below I discuss the relationship between credit quality and liquidity. In March Coolabah bought and sold almost $1 billion of bonds at a time when markets were being subject to one of their worst shocks in the last 100 years. Over April, May, June, and July Coolabah has (gross) sold more than $2.9 billion of credit (and net sold over $800 million at the time of writing). In total, we have bought and sold more than $8.9 billion of cash bonds in the first 6 to 7 months of 2020, which would make us the most active participant in the sector according to feedback from leading market-makers.

In March liquidity was generally only available in assets with very strong credit quality. For years Coolabah has avoided bonds with correlated downside default and liquidity risks precisely because we have been concerned that they would be non-tradeable (ie, illiquid) in any serious downside scenario. This includes bonds issued by commercial property trusts, hotels, residential developers, retailers, airlines, and non-bank lenders offering non-prime finance to borrowers who cannot get credit from banks. These are highly pro-cyclical credit exposures and tend to suffer badly during any recession like the one we are currently experiencing. Put differently, these cyclical industries have correlated downside and liquidity risks, which Coolabah has been keen to avoid.  

The biggest market-maker in Aussie credit, ANZ, wrote to clients some months ago to explain this dynamic. The global head of trading commented that “in our view the primary driver of the poor liquidity and the recent extreme spread widening is the inherent credit and solvency risk of corporates". “If investors are able to access repo on corporates, then it may alleviate some forced selling in times of stress, but that is, in our opinion, minimal,” they continued. “Cheaper funding of bonds in a financial crisis doesn’t take away fundamental concerns of credit worthiness. From the perspective of a market-making desk, we can say with confidence that the thoughts of where we could fund our corporate bond holdings was not a factor of note when bidding in March and April. Foremost was credit worthiness.”

You can click on this link to watch the full 10 minute interview below. You can also read this previous Livewire article in which I explained how diversification in fixed-income can be used as a trojan horse to load-up on correlated credit and liquidity risks that wreak havoc during tough times...

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