Fine-tuning cash portfolios through liquidity management.
With marketable cash investments, liquidity generally means how easily and quickly one may exchange a security for cash with little price concession from its going rate. The two key factors in measuring liquidity are how long it takes to complete the transaction and how much of a price "haircut" must be taken on the sale.
Investors who intend to hold securities to maturity often make the mistake of downplaying the importance of liquidity. At a minimum, an unexpected cash need may force early redemption of an existing holding. Concerns with credit or interest rate risk may also require a sale to avoid future losses. Additionally, liquidity has economic value. In other words, a less-liquid security should carry a more attractive price than an otherwise identical, but more liquid security.
For example, a two-year floating-rate note with three-month interest rate resets may provide 0.05 percent to 0.10 percent more annual yield than a three-month commercial paper from the same issuer. The former may be less liquid, but is otherwise almost identical to the commercial paper in risk exposure.
Factors Influencing Liquidity
Portfolio liquidity results from many factors, including general financial market conditions and specific security features. Among the more prominent factors, listed below are five that may be relevant to treasury cash accounts:
1. Size and Breadth of Market Sectors: U.S. Treasury securities are among the most liquid bonds in the world. Aside from strong credit backing from Uncle Sam, they are liquid because they are widely held. Generally speaking, liquidity is better in large market sectors with higher debt outstanding and higher daily trading volume, such as federal agencies and corporate securities. The municipal, asset-backed and commercial mortgage debt markets may be less liquid by comparison.
2. Market's Risk Appetite: The general market's sentiment towards liquidity risk premium can be a significant factor. When interest rates are low, credit is easy and investors tend to demand a lower premium for liquidity. When central banks embark on tighter monetary policies or when geopolitical risk is on the rise, credit uncertainty increases and investors typically want to stay with more liquid securities and, thus, demand a higher yield for less-liquid products.
3. Credit Ratings: Investors often associate credit risk with liquidity. Securities with credit ratings of triple-A, double-A or single-A are generally very liquid. Bonds rated Triple-B or below-investment-grade are often considerably less liquid, as there are fewer interested buyers. Similarly, a security that is a downgrade candidate will usually be less liquid than one of the same rating that is on the verge of an upgrade.
4. Round Lots: Bond traders often prefer to trade in "round lots." Although no industry standard exists, these are the preferred minimum trading units, ranging from $1 million to $5 million. Bonds can be bought and sold in any increments of $25,000, but "odd lot" transactions are often more difficult to complete.
5. Outstanding Size: Securities with $150 million or more in outstanding par amount are considered very liquid. This figure is the minimum amount to be included in major bond indices. In recent years, issuers, including Fannie Mae and Freddie Mac, issued deals in the billions of dollars, which greatly improved liquidity of these deals. By contrast, the same issuers' medium-term note programs, or bonds issued on an as-needed basis from a shelf registration, are much smaller and usually less liquid.
How, then, can treasury professionals better manage liquidity risk in their portfolios? In addition to paying attention to the five factors above, the following measures may help improve a portfolio's liquidity profile.
* Be a Comparison Shopper: A rule of thumb for owning marketable securities is to ensure that they have multiple dealer support, preferably from more than three dealers. Investors may want to be skeptical of proprietary brokerage or bank products.
* Do Your Homework: The proliferation of new cash products with special features requires more due diligence. Many of the securities have derivative, leverage or extension features that may affect their liquidity.
* Get Paid for Liquidity Risk: Liquidity has its price. When you don't need immediate liquidity, invest in something with higher yield to compensate for risk.
* Beware of Over-diversification: It is prudent to reduce your risk by diversifying your holdings; however, try to avoid owning odd-lot positions that may cut liquidity.
Lance Pan (Lpan@capitaladvisors.com) is Director of Research at Capital Advisors Group Inc., where he leads the fundamental credit research and individual security selection strategies.
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|Date:||Sep 1, 2006|
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