JUNE 2016
On the Municipal Market
Steps Ahead of a Looming
Liquidity Challenge
Nicholos Venditti, cfa | Portfolio Manager and Managing Director
Not always the talk of the town, liquidity in the fixed income market still looms as a detrimental risk. It could easily and
quickly take center stage, however, given the right mix of economic scenarios and circumstances. Here’s a look at how the
liquidity landscape arrived at where it is and why we believe Thornburg’s ability to think a little differently in this space is
helping to protect and prepare for a potential crisis.
A Quick Look Back
Let’s take a trip back to early 2013. Much
like today, fixed income investors were
struggling to find the income they so desperately desired. The income component
of total return remained elusive, while
price appreciation seemed endless. Income
availability aside, they were good times
for fixed income investors and municipal
investors in particular. Rates kept moving
lower, an actual rate hike was years away,
the Puerto Rico credit story was still
months from spilling itself and there were
10 buyers for every seller. Times couldn’t
have been better. That is, until the fateful
day when Federal Reserve Chairman Ben
Bernanke mentioned tapering.
All of a sudden rates shot up from a low
of 1.63% in early May to 2.61% in late
June and to over 3% by year end. Fixed
income investors, who had been waiting for the dream to end for some time,
began to flee the space the very minute
the Fed began discussing the slow end of
quantitative easing.
Following the initial tapering discussion,
the fixed income markets started to freeze
as the universe tried to wrap its mind
around Bernanke’s statements. For the
first time in a long while there were no
longer 10 buyers for every seller. In fact,
more often than not, there were no buyers at all. Luckily, the market sorted itself
out, at least from a liquidity perspective,
and the phenomena lasted only for three
or four days.
At the end of 2013, most analysts and
pundits were forecasting Armageddon for
the fixed income market in 2014. When
predictions failed to play out, the collective memory of market participants began
to fade. While most remember the rise in
rates associated with the 2013 “taper tantrum,” few remember that for three days
in June the biggest risk that faced the
market was a lack of liquidity.
The Current State
Today, the municipal market feels a lot
like early 2013. Bond investors are still
struggling to find income, but price appreciation is strong, as rates rallied to
1.66% despite the much-anticipated Fed
tightening in December. Credit spreads
are tight, and although the market is
still inundated with Puerto Rico news,
general credit appears to be improving.
Money is flowing into the municipal
market and—like 2013—there are 10
buyers for every seller.
All that said, is the greatest threat facing
the market today a lack of liquidity? If yes,
what should an investor do?
Liquidity risk in the fixed income markets
has been exacerbated by several factors,
perhaps most notably are government regulations. In the past, investment banks
would typically act as liquidity providers
during market disruptions. By acting as
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Figure 1 | Could Market Withstand Herd’s Flight from Corporates?
In their reach for yield since 2008, far more retail investors chose corporate bonds (over municipals, agencies/government issues, etc.). If herd mentality holds true, a major market disruption could create an unprecedented liquidity crisis if
everyone sells at once.
Treasury
Agency & GSE
Municipals
Corporate and Foreign Loans
25%
% Market Share
20%
15%
10%
5%
2016 Q2
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
0%
Source: Federal Reserve, Financial Accounts of the United States, September 30, 2016.
GSE = Government Sponsored Enterprises
the “buyers of last resort,” banks helped
mitigate downside pricing risk for portfolios that needed to raise cash to meet redemptions. Government regulations have
effectively reduced the size of the balance
sheets of those financial institutions. If we
see another liquidity event, banks may be
unable, or unwilling, to step in to help stabilize the market.
In addition to reducing financial capital
dedicated to the fixed income markets, big
banks are starting to reduce human capital
as well. Low rates have driven down profitability of fixed income trading desks,
leading many of the major players to severely reduce headcount. So, as margins
shrink and banks cut staff on their fixed
income trade desks, can they adequately
respond to a massive run for the exits?
Moreover, the landscape of fixed income
investing has changed since the financial
crisis of 2008 (see shaded area in Figure
1). The municipal market has always been
heavily influenced by the retail investor.
Recently, retail ownership in the corporate
market has ticked up. Figure 1 uses mutual
2
fund ownership, closed-end fund ownership, and exchange-traded fund ownership
as a proxy for measuring retail investment.
Why is this a new potential threat to liquidity? Retail investors tend to act in
tandem and usually overreact to market
disruptions. Any disturbance in the fixed
income markets could cause retail owners
to hit the sell button at the same time. At
that point, banks will be forced to make a
relative value decision between corporates
and municipals when determining which
securities to add to their balance sheets.
Such structural changes to the fixed income markets pose a threat to fixed income investors, but they aren’t alone in
driving liquidity risk. Investor behavior
has created problems too. The prolonged
low-interest-rate environment has created
disconnect between the risk tolerance of
individual investors and the risks they are
currently taking in their portfolios. The
demand for yield has driven investors and
portfolio managers further out on the risk
spectrum, aggressively seeking more and
more income.
No case study makes this fact clearer than
the Third Avenue Focused Credit Fund.
The fund’s investors and portfolio managers, hungry for income, took on excessive
risk in the process. Worse than that, the
portfolio added the risk by buying ever
more pricey credits. As they all chased
the high-yield space, the lower their yields
became (while spreads tightened). Essentially, they were investing in the “worst
of the worst” at historically high prices.
So, when credit spreads in the corporate
market started to widen and fund performance suffered, investors demanded their
money back, en masse. Liquidity, or lack
thereof, suddenly (but not surprisingly)
became more important than everything
else, not only to redeeming investors, but
to the perpetuity of the fund itself.
A Look Ahead
The Third Avenue debacle brought the
discussion of liquidity back to the forefront after its long hiatus. It is important
for investors to recognize that while Third
Avenue is somewhat unique given their
Widespread credit deterioration, or any other catalyst
that causes a wide rotation out of fixed income
products, could be devastating for any portfolio that
needs to sell bonds to meet cash needs.
high-risk-investment approach, a similar event could impact the broader fixed
income markets with the right macroeconomic circumstances. An increase in
rates, widespread credit deterioration, or
any other catalyst that causes a wide rotation out of fixed income products, could
be devastating for any portfolio that needs
to sell bonds to meet cash needs.
While it is impossible to entirely insulate a
portfolio from liquidity risk, Thornburg’s
global fixed income and municipal investment teams have been making a concerted
effort to help protect our portfolios from
another such event.
Durations Down, Quality Up
The market has not been compensating
investors to take risk. Credit spreads, particularly in the municipal market, have
remained incredibly tight. Absolute rates
are extremely low and the slope of the
yield curve has not been enticing enough
to take excess duration risk. As such, we
have shortened the durations of most
Thornburg fixed income portfolios. In this
environment, we believe adding “worst of
the worst” credits when they’re at their
most expensive ever is a fool’s errand.
Given the excessive costs of taking on more
credit risk, Thornburg has been taking it
off the table, investing in carefully selected
higher-grade credits. This has increased
the average credit quality of the portfolio
line-up. The ability to focus on credit quality is imbued by our disciplined portfolio
construction process centered on fundamental, individual s­ecurity selection. We
are guided by this in any environment, but
it is especially beneficial to reduce overall
credit risk exposure right now.
Far from invigorating, these portfolio
management decisions nevertheless are
effective, necessary, and make total sense
from a risk/reward standpoint. That is,
the steps are beneficially creating portfolio characteristics traditionally associated
with higher liquidity credits, which are
typically higher-rated bonds and bonds
with strong legal securities.
getting more headlines lately, but liquidity
has always been one of the risks for which
we have demanded compensation since
we started running fixed income funds in
1984. Liquidity risk isn’t always as riveting as debates over troubled credits or potential macroeconomic risks, but we have
always held that the ramifications of a liquidity event could be every bit as painful.
We believe our focus on quality credit
research and our actively managed approach to laddering and other fixed income strategies will provide us with the
foundation and flexibility to not just
weather a liquidity storm but to exploit
market dislocations for the benefit of
A derived benefit of our selective de-­ our shareholders. n
risking is higher-than-average cash and
reserve positions across our fixed income
portfolios. This way, we’re structured to
meet redemptions that may arise with
Nick is portfolio manager for Thornburg
cash, rather than proceeds from “fire sale”
Investment Management. He joined
bond trading. We believe shareholders are
Thornburg in 2010 as a fixed income
best served when their fund is positioned
research analyst and was promoted to
to be a provider of liquidity when it’s
associate portfolio manager in 2011 and
needed the most, rather than the victims
portfolio manager and managing direcof a lack of it if a crisis hits.
Not Led by the Fed
Positioning on the yield curve has also
been a driver of liquidity, because investors may be reluctant to buy longer-dated
bonds if they perceive an increase in rates
or a steepening of the yield curve. That’s
why we manage our core portfolios to a
laddered structure. At its core, active laddering provides a constant source of cash
flows as bonds mature each year. Therefore, liquidity in the portfolio is naturally
boosted by our active laddered approach
to fixed income.
tor in 2015. Prior to his joining Thornburg
Investment Management, Nick spent three
years working as assistant vice president
for bond insurer FSA (now merged with
Assured Guaranty Corp). Nick earned an
MS in finance from Syracuse University,
an MA in applied economics from the
University of North Carolina - Greensboro, and a BA from Trinity University.
For more articles and information about
our active approach to fixed income visit
www.thornburg.com/fixedincome.
Generally, laddering involves investing
in bonds at staggered maturities so that a
portion of the portfolio will always mature each year. As bonds mature, they
generate cash to be reinvested or used to
meet shareholder liquidity needs. Money
in, money out, money in. Repeat.
The Thornburg fixed income team manages with one core philosophy: get rewarded if you’re going to take risk. Liquidity risk is no different. It may be
3
Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the
underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. This effect is more pronounced for longer-term
bonds. Unlike bonds, bond funds have ongoing fees and expenses. Investments in lower rated and unrated bonds may be more sensitive to default, downgrades, and market
volatility; these investments may also be less liquid than higher rated bonds. Investments in derivatives are subject to the risks associated with the securities or other assets
underlying the pool of securities, including illiquidity and difficulty in valuation. Investments in the Funds are not FDIC insured, nor are they bank deposits or guaranteed by a
bank or any other entity.
Any securities, sectors, or countries mentioned are for illustration purposes only. Holdings are subject to change. Under no circumstances does the information contained within
represent a recommendation to buy or sell any security.
There is no guarantee that the Funds will meet their investment objectives.
Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
High yield bonds may offer higher yields in return for more risk exposure.
Laddering involves building a portfolio of bonds with staggered maturities so that a portion matures each year. Money that comes in from maturing bonds is typically invested in
bonds with longer maturities at the far end of the portfolio.
The laddering strategy does not assure or guarantee better performance than a non-laddered portfolio and cannot eliminate the risk of investment losses.
Duration – A bond’s sensitivity to interest rates. Bonds with longer durations experience greater price volatility than bonds with shorter durations.
Yield Curve – A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.
The views expressed by the portfolio managers reflect their professional opinions and are subject to change. Under no circumstances does the information contained within represent a recommendation to buy or sell any security.
Thornburg mutual funds are distributed by Thornburg Securities Corporation.
Past performance does not guarantee future results.
Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary
prospectus containing this and other information, contact your financial advisor or visit thornburg.com. Read them carefully
before investing.
11/23/16
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