When the coronavirus prompted a collapse in both economic activity and equity markets in March, it put an end to the longest bull market in history. Unprecedented steps by business and governments to slow transmission of the virus all but halted the global economy and adding insult to the viral injury, Russia and Saudi Arabia’s disagreement over oil production curtailments resulted in a significant drop in energy prices. Volatility ruled supreme, while liquidity, especially in fixed income markets, dried up.
Because they are not traded on public exchange, trading of fixed income securities tends to garner less attention – but the past month-plus has been very turbulent in these markets. When concern started mounting at the end of February about the health and financial impacts of the virus in the West, liquidity in fixed income markets quickly eroded. Many institutional investors then began rebalancing their portfolios in mid-to-late March after equity markets gapped down, by selling fixed income and buying equities. This rebalancing process was much more challenging for fixed income than in previous market corrections, hampered as it was by many buy-side investors trying to get out the same door at the same time, clogging the exits.
During the global financial crisis, it was not uncommon to budget several business days to sell a few million dollars of an investment grade corporate bond. By comparison, at times in this past month, even high-quality, short-dated corporate bonds became challenging to move and as a result, senior Canadian bank bonds widened 200 basis points almost overnight. In one extreme example, it was even a challenge to find a bid for a regulated A-rated utility bond maturing in six days. Although spreads did widen as much (or more) in the global financial crisis, the widening occurred over a longer time period and higher-quality credit was seldom as difficult to trade, particularly shorter-dated paper.
The swiftness of the change in market conditions is partly a result of changes in bank balance sheets, which penalize bank dealers for holding inventory. Whereas before, bank dealers might take the other side of a trade themselves (and so take it on their balance sheet until they could find a buyer), they now largely act as agents in transactions and so need to first line up a buyer for each seller before a trade can happen. This introduces friction into the process, especially with securities like bonds that are traded over the counter.
What can pension trustees do to navigate these difficult markets?
Firstly, they can take a close look at liquidity needs and give investment managers as much notice of expected portfolio changes as possible. As discussed above, additional attention on short-term liquidity needs is important in times like these. Beyond expected cash flows to fund pension or other member benefits, it is also important to assess any potential capital calls in private markets within the portfolio and notify other investment managers of any pending ones as soon as possible. This way, they can raise the funds over a longer timeframe, likely achieving better pricing than if they are only given a couple of days. It may also be advisable to postpone any large, elective transitional portfolio changes until markets are functioning normally.
In addition to focusing on liquidity needs, rebalancing is a very important element of risk management. Following periods in which an asset class significantly outperforms, the portfolio will likely become overweight that asset class, and the portfolio will have shifted from its target strategic asset allocation. At a minimum, rebalancing back to your original allocation will restore the portfolio to its long-term target risk/return profile. In highly volatile markets, you may need to review your rebalancing needs more frequently.
Further, communication with your investment managers is key, especially during times of great uncertainty like these, and you should expect your investment managers to be communicating more with you, not less. Transparency during tough times is a mark of integrity. And, understanding your managers’ business continuity plans is critical, especially in regards to how any changes may impact the investment process and plan sponsor communication. Any potential changes in the investment mangers’ positioning and strategy are also important to understand, as is ensuring that all compliance functions continue to function effectively and that reporting of any breaches of investment guidelines or policies resulting from downgrades or market movement will continue to occur on a timely basis.
While market volatility will likely remain in the near term, historically, periods of heightened volatility have led to opportunity for long-term investors who are willing to be patient. However, in this short-term period of heightened uncertainty and impaired liquidity, investors can help by considering their liquidity needs carefully, actively rebalancing as needed, and placing additional emphasis on communication with their investment managers.
Update: At the time of writing, liquidity was a major issue in the corporate bond market. The news announced yesterday that the Bank of Canada will be buying up to $10 billion Canadian corporate bonds with minimum rating of BBB should significantly improve liquidity in this market. Corporate bonds valuations immediately responded materially on the news.
This piece was co-authored by Mike Wallberg, vice-president of marketing and communications at Leith Wheeler Investment Counsel.