In a storm, you want to be able to reach higher ground. Recent market volatility – sparked by concerns over interest rates, inflation, global trade, the tech sector and more – has many investors shifting toward more defensive portfolio positions.
Having the flexibility to manage and deploy portfolio liquidity amid rapidly changing and challenging conditions is like having a ladder to higher ground: It may help preserve capital while producing income.
The liquidity ladder
Soon after the financial crisis, PIMCO developed a concept, or image, that we called the “concentric circles of risk” to illustrate levels of credit risk in a world characterized by central bank quantitative easing (QE). In the center of the circle were the lowest-risk assets (for example, U.S. Treasury bills), while the outer circles represented more risky asset classes (such as corporate bonds and real estate).
Today, conditions are changing once again as central banks wind down their QE programs and move to normalize rates. In this environment of tightening financial conditions, we are carefully watching liquidity: We need to understand how it ebbs and flows, how it affects the pricing of risk assets and how it is managed by investors, who all have different objectives, time horizons and tolerances for short-term losses.
Our short-term portfolio management team conceptualizes liquidity conditions today using the image of a ladder, with market participants on different rungs depending on their ability to affect the pricing of liquidity, other market participants’ reaction functions and changes in the valuation of liquidity itself.
As an investor, it is crucial to know where you stand on the “liquidity ladder.” Conceptually, the ladder represents the broad but dynamic global liquidity system, and you may find yourself shifting up or down the rungs depending on changes in regulation, market conditions that affect the cost of liquidity, and most important, the type of investment strategy you adopt.
Liquidity “price makers” tend to have longer-dated investment horizons and fewer concerns over day-to-day fluctuations, and they stay near the top of the ladder. These currently include central banks, pension funds and regulated entities like insurance companies and money market funds. The less flexible “price takers” are near the bottom of the ladder; these may currently include hedge funds, passive ETF/ETN investors, market-makers and securities lenders. They can at inopportune times be forced sellers of otherwise attractive assets as they attempt to navigate the inclement conditions of a risk-off market. Our views on liquidity are affected by not only how far apart buyers and sellers are (bid-offer spreads) but also the risk appetites we observe from all of the participants on the ladder.
We believe that active portfolio managers can position themselves on the rungs as circumstances change or opportunities present themselves. Active investors may employ liquidity defensively and also as an opportunistic tool – seeking reward for assuming risk. Our active management approach attempts to anticipate changes in global liquidity and dynamically assess and reposition our various investment strategies on different rungs of the liquidity ladder as conditions warrant. In general, we aim to be sellers of liquidity when others are buyers and buyers of liquidity when others are sellers.
Our positioning on the liquidity ladder is key to adding value for investors. We aim to manage the divergent interests of price makers and price takers in ways that benefit our investors ‒ without only relying on “bets” on market outcomes, like interest rates, to outperform.
Up and down the rungs
In recent weeks, market participants have been continuously re-evaluating the function, price and use of liquidity, largely as a result of three altered market conditions:
Higher funding costs related to constrained seasonal changes and quarter-end illiquidity
A higher Libor rate and wider Libor/OIS spreads (the difference between Libor and the overnight index swap rate), which have increased the relative cost of funding for many banks
Changing supply and demand dynamics in the front end (i.e., more T-bill and short-dated corporate supply versus waning demand from corporate treasuries and foreign investors)
Just one example of active management in action in this environment would be to buy front-end zero- to 18-month corporate bonds when lower-rung participants are forced sellers. Providing they hold up well to independent credit analysis, many of these bonds can offer attractive yields of 2.50% and higher with limited interest rate exposure.
Active investors should constantly monitor the ebbs and flows of liquidity conditions. We suggest investors be prepared for a volatile ride, and bolster their portfolios with flexibility and liquidity to withstand brief but torrential rain showers when market sentiment turns negative while watching for attractive risk/reward opportunities. Know where you stand on the liquidity ladder so you can be prepared to seek higher ground.
Learn more about active short-term investment opportunities in our recent blog post, “Tapping Yield at the Front End of the Curve.”
Jerome Schneider is PIMCO’s head of short-term portfolio management and a regular contributor to the PIMCO Blog.