(Il)liquidity in credit markets

Christopher Joye

Coolabah Capital

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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General Disclaimer: Past performance does not assure future returns. All investments carry risks, including that the value of investments may vary, future returns may differ from past returns, and that your capital is not guaranteed. This information has been prepared by Coolabah Capital Investments Pty Ltd (ACN 153 327 872). It is general information only and is not intended to provide you with financial advice. You should not rely on any information herein in making any investment decisions. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The Product Disclosure Statement (PDS) for the funds should be considered before deciding whether to acquire or hold units in it. A PDS for these products can be obtained by visiting www.coolabahcapital.com. Neither Coolabah Capital Investments Pty Ltd, EQT Responsible Entity Services Ltd (ACN 101 103 011), Equity Trustees Ltd (ACN 004 031 298) nor their respective shareholders, directors and associated businesses assume any liability to investors in connection with any investment in the funds, or guarantees the performance of any obligations to investors, the performance of the funds or any particular rate of return. The repayment of capital is not guaranteed. Investments in the funds are not deposits or liabilities of any of the above-mentioned parties, nor of any Authorised Deposit-taking Institution. The funds are subject to investment risks, which could include delays in repayment and/or loss of income and capital invested. Past performance is not an indicator of nor assures any future returns or risks. Coolabah Capital Institutional Investments Pty Ltd holds Australian Financial Services Licence No. 482238 and is an authorised representative #001277030 of EQT Responsible Entity Services Ltd that holds Australian Financial Services Licence No. 223271. Equity Trustees Ltd that holds Australian Financial Services Licence No. 240975. Forward-Looking Disclaimer: This information may contain some forward-looking statements. These statements are not guarantees of future performance and undue reliance should not be placed on them. Such forward-looking statements necessarily involve known and unknown risks and uncertainties, which may cause actual performance and financial results in future periods to differ materially from any projections of future performance or result expressed or implied by such forward-looking statements. Coolabah Capital Investments Pty Ltd undertakes no obligation to update forward-looking statements if circumstances or management’s estimates or opinions should change except as required by applicable securities laws. The reader is cautioned not to rely on forward-looking statements.

Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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