The ‘WeWork’ of the fixed income world

Gopi Karunakaran

Ardea Investment Management

Liquid securities are those that can be readily bought or sold in sufficient volumes, at reliably transparent prices, without incurring punitive transaction costs. Illiquid securities are those that fail to meet these criteria to varying degrees. Liquidity is a spectrum rather than a binary concept.

In addition to providing the ability to transact freely, liquidity (or lack thereof) also plays a big role in how confident you can be about an investment’s current valuation. As liquid securities are regularly bought and sold by many market participants, they incorporate a lot of information value in the prices at which they transact. This in turn provides confidence around the current market value of these securities and your ability to buy or sell at prices that do not vary drastically from this valuation.

By contrast, the price of an illiquid security is determined by infrequent transactions between a much smaller group of buyers and sellers, which in turn means the price you end up transacting at might vary significantly from the previous valuation, even if the broader market is unchanged.

There’s an important distinction here between ‘market value’ and ‘fundamental value’. The former is an objective measure that simply reflects the valuation an investor can realise if they buy or sell at the current market price. The latter is a subjective opinion about valuation.

For example, a stock picker might think the market has ‘got it wrong’ on the valuation of a certain company and believe that the ‘true’ fundamental value of the stock is much higher than its current market price implies. However, no matter how strong their conviction they will only ever be able to transact at that true fundamental valuation if consensus shifts to their view, causing the market price to adjust accordingly.

Whatever your opinion about true fundamental value, if you need to buy or sell a security today, the only price that matters is the current market price.

For liquid investments the market price has depth to it because it reflects the consensus view of many market participants who are actually transacting at that price. By contrast, an illiquid investment doesn’t benefit from this type of consensus based depth and can therefore be more vulnerable to sharp price fluctuations driven by marginal buying or selling activity.

On the surface, the now highly publicised WeWork saga is about a charismatic founder attempting, and ultimately failing, to get away with excessive tech bubble like valuations and highly unusual corporate governance standards. (Fortune provides a good summary here.)

Beneath the surface though, there’s a more generally applicable lesson about how unreliable the valuations of illiquid investments can be.

Just last month WeWork’s IPO valuation was being touted at sky high tech unicorn levels of up to USD48bn but a few weeks later the company was forced to accept a 90% lower takeover offer to avoid bankruptcy.

Did WeWork’s business or industry change so dramatically over those few weeks? Clearly not. Rather, it turned out there was a big disconnect between the way that illiquid WeWork stock was being valued in private markets, based on a few transactions between a small group of venture capital investors, and the valuation that more liquid public equity markets were willing to assign.

Those early investors in illiquid private WeWork stock can argue all day long that public equity markets simply didn’t ‘get’ the true fundamental value of the company. But in the end those arguments are irrelevant because the only price that matters for those investors wanting to cash out of their illiquid stock is the market price … and that turned out to be a lot lower than they expected.

In the journey of price discovery from illiquid investment to an aspiring publicly listed and liquid stock, rather than cementing its position as a magnificent tech unicorn, WeWork turned out to be a very ordinary horse with a plastic horn stuck to its forehead. Those sky high but illiquid private market valuations turned out to be spectacularly unreliable.

We can see parallels between the WeWork saga and segments of the fixed income market where, fuelled by yield hungry investor demand, a growing proportion of increasingly illiquid corporate bonds and loans are now sitting in investor portfolios at expensive valuations.

These valuations, rather than having the depth that liquid investments benefit from, are based on infrequent transactions between a small number of market participants … just like WeWork’s illiquid private stock.

Unlike WeWork stock though, these bond investors may simply be able to hold the bonds to maturity and earn the yield, as long as the companies that issued them don’t default. But if at any time they need to sell, they will have to go through a price discovery process to find some liquidity and much like WeWork’s investors they may get a rude shock when their illiquid valuations don’t hold up to broader scrutiny.

Most vulnerable are fixed income portfolios that are building up a growing mismatch between the daily liquidity they promise investors and the illiquidity of the bonds they hold.

Morningstar explains it this way:

“Bad things happen when funds that are priced daily, and that offer daily liquidity to shareholders, hold securities that are neither priced frequently nor can be readily traded.”

– Morningstar, “The perils of private (and illiquid) fund investments”, July 2019

This issue is becoming more widespread because structural changes in fixed income markets have even compromised liquidity in some segments of global fixed income markets that used to be liquid (details here).

This hasn’t been obvious so far because the liquidity deterioration has been masked by a constant flow of new yield seeking capital flooding into higher yielding but increasingly illiquid segments like leveraged loans, high yield corporate bonds and emerging market debt. It’s only when the inflows turn to outflows that they may find their exit prices are far lower than they thought.

Here’s how such a scenario may play out.

Global economic growth deteriorates to a point where corporate earnings get hit and equity markets fall materially. This in turn causes years of rampant yield seeking inflows to turn into outflows as investors get more concerned about credit risk and there is a general flight to safety.

Initially the portfolios that hold illiquid bonds and loans are able to meet investor redemption demands using cash or other liquid securities they hold. However, if the outflows persist, they eventually run out of liquid securities to sell and are forced to start selling illiquid holdings.

Given those bonds and loans were illiquid to begin with, their valuations never had much depth, and the price discovery process reveals that the prices at which they can actually be sold are far lower than expected.

The valuations at which illiquid investments are held in portfolios is based on scant transactional evidence and therefore may not at all be representative of the true clearing price of risk (i.e. the price at which they can actually be bought or sold). This only gets tested when someone is forced to sell and can trigger a domino effect whereby other comparable illiquid investments also have their prices revised downward, causing sizeable losses for investors.

As we saw in the 2008 financial crisis, even if these investments end up being fundamentally sound, the cascade of forced selling into illiquid markets causes many portfolios to end up realising losses in the short term.

In the meantime, illiquid bonds and loans can give a false sense of security because they exhibit low price volatility most of the time. This is not because they are inherently low volatility investments but rather that they rarely trade and therefore their prices are not updated regularly. This in turn means they can sit in a portfolio valued at an unchanged but stale price for a long time, giving the illusion of low volatility, but then suddenly drop when someone tests the market to find a clearing price.

These considerations are particularly relevant for fixed income investments because many investors use fixed income as the defensive part of their broader investment portfolio and therefore expect these investments to hold up well in adverse market environments. They therefore need to have confidence that the prices at which their bond and loan holdings are valued are actually representative of the prices at which they could sell if needed.

This is not a binary question of whether illiquid bonds are good or bad. It can make sense to take illiquidity risk when it is well compensated, and the time horizon of capital is appropriate. The problem arises when illiquidity risk creeps into portfolios that are expected to be liquid and are intended to play a defensive role.

So far we have only seen isolated instances of illiquid holdings causing problems for fixed income portfolios (examples here, here and here) but we expect to see more as the desperate search for yield compels portfolios not well suited for holding illiquidity risk to push the limits, often without it being obvious until it’s too late.

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Co-Chief Investment Officer
Ardea Investment Management

Gopi Karunakaran is Ardea’s Co-Chief Investment Officer (Co-CIO), together with Ben Alexander. In this capacity they both share responsibility for overseeing the investment process and investment team, with ultimate accountability for ensuring the...

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