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05/21/2015

ĿİQŲİĐİȚỲ

Bǿňđ PMș Ǻđđįňģ Ŀįqųįđįțỳ fǿř Přǿțěčțįǿň, BǻřģǻįňĦųňțįňģ

Andrew Greene

Bond fund managers are prepping for a possible market correction by adding liquidity to cover redemptions. Not tobe outdone, other bond fund managers are adding liquidity for a different reason; they are looking to capitalize onwidening credit spreads to buy bonds on the cheap.

The challenge, or opportunity depending on the perspective, is that there is a “mismatch of liquidity” in thecorporate bond market today in which everyone is on the same side of a trade, says Wes Sparks, head of U.S.credit at Schroders. When news is good and sentiment is positive, there is no inventory. When the outlookdarkens everybody wants to sell, he says.

Sparks’ comments coincide with a recent global sell­off of government bonds that saw sovereign debt pricestumble precipitously. That’s fueled concerns that the overall lack of liquidity in the bond markets could spelltrouble for fund managers who are forced to sell positions at steep discounts in order to meet redemptions.Others, like Sparks, see that scenario as an opportunity.

He said he is preparing his funds to capitalize on the herd mentality currently gripping the corporate bond marketsby loading up on cash in his portfolios. “The next correction will be a buying opportunity,” he said recently at apress event.

Sparks is not alone. Whether to meet redemptions or to capitalize on opportunities, bond managers have addedsignificant amounts of liquidity to their portfolios. In fact, taxable and muni bond funds’ liquidity ratios hit 7.7% inthe first quarter, according to Investment Company Institute data. For all of last year it hit 7.5%, a 26­year high.

The benefit of having a sizeable allocation to cash and liquid securities is that it can be quickly deployed to buydiscounted bonds when credit spreads widen or to meet redemptions. But the downside is that cash returns nextto nothing and too much could undercut fund performance.

As a result, bond funds have been adding more liquid holdings that generate returns in line with the bonds theytypically hold. To that end, they have increased their holdings of derivatives and exchange­traded funds, amongother securities. And some high yield and multi­sector bond funds have steadily ramped up their equity holdings,which are generally more liquid than bonds.

Larry Pavelec, the portfolio manager of the Nicholas Funds’ high yield funds, has significantly increased theNicholas High Income Fund’s (NCINX) holdings of equities to 8.4% at the end of April, according to Morningstardata. That’s the highest level of equity holdings held by the fund in 10 years, and nearly double the amount of

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equities the fund held as recently as last October.

Pavelec and research analyst Marco Spada take a bottom­up, long­term value approach to investing in high­yieldbonds. In his letter to shareholders in the fund’s most recent annual report, Pavelec wrote: “One of our core beliefsis to take advantage of opportunities where we feel markets have overreacted to news. Often times the emotionalreaction of investors will create mispriced securities during these periods of volatility.”

The fund has steered its bets on equities into securities anticipated to perform well in a rising interest rateenvironment. That includes convertible and preferred securities, high dividend­paying equities and master limitedpartnerships, he notes. The securities can provide a buffer when rates rise and are in some cases higher qualitythan the high yield bonds the fund owns, Pavelec says. “And equities are more liquid,” he says, quickly adding,“that’s an added benefit, but not the primary benefit.”

"İf ỳǿų șįfț ỳǿųř ẅǻỳ țħřǿųģħ țħě čǻřňǻģě țħěřě ǻřě șǿmě ňįčě ǿppǿřțųňįțįěș.Ẅě’řě ňǿț ẅǻįțįňģ fǿř țħě ňěxț čǻțǻșțřǿpħě, bųț ẅħěň įț đǿěș ǿččųř țħǻț’șẅħěň ǿųř įňțěřěșț jųmpș.”

That liquidity can be quickly deployed to buy bonds of fundamentally sound companies that are temporarily tradingat a discount. Pavelec points to the roller coaster ride the energy sector went on over the past six months as anexample of how markets can sometimes overreact. “The market was pricing in pretty dire expectations and thesame thing happened with high yield bonds,” he says.

An event like a market or sector dislocation or a geo­political event can generate an attractive discount, Pavelecnotes. “That’s not to say every security is one you want to jump on,” he says. “But if you sift your way through thecarnage there are some nice opportunities. We’re not waiting for the next catastrophe, but when it does occurthat’s when our interest jumps.”

Thrivent Financial is another firm that has adjusted its portfolios to add greater liquidity for defensive purposes tomeet redemptions as well as capitalize on buying opportunities, according to Mark Simenstad, head of fixedincome funds and separate accounts.

The lopsided liquidity in the fixed income markets has been exacerbated by low interest rates and regulations thathave wiped out much of the inventory once provided by the sell side, Simenstad says. To manage liquidity risk,Thrivent’s fixed income funds have used credit default swaps, treasury futures and ETFs, Simenstad notes.

Thrivent is also looking for opportunities to buy and, like Nicholas Funds, made some purchases in the energysector while there was wholesale selling of high yield energy bonds. Whether it is the taper tantrum of 2013, therecent sell­off of European sovereign debt or Meredith Whitney’s flawed prediction of a municipal debt meltdown,the lesson is that there are opportunities to be found for those who take a long­term view on the markets, he says.

Gene Morrison, VP and product manager for the relative return team at Loomis, Sayles & Co. says they do notexpect volatility to pick up dramatically in the markets, but he says that “liquidity is important and something welook at every day.” And even though Loomis’s outlook does not anticipate widespread volatility or widening creditspreads, the liquidity on hand is for opportunistic moments as well as to meet redemptions, he says.

“Do we expect spreads to widen fundamentally? No. Could they? Yes. That’s why you want to have cash onhand,” he says.

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