Liquidity Risk And The Role It Plays In Your PortfolioAuthor: Adam GreenLast Updated: October 18, 2013 In the news a lot lately is the subject of bond market liquidity. New regulation aimed at lowering leverage and speculation in the financial system in the wake of the credit crisis has resulted in smaller broker/dealer balance sheets, which in turn have hurt liquidity in some parts of the bond market.Those sounding the alarm say those broker/dealers who have historically stepped in and provided liquidity in times of market stress are no longer able to play the same role. Using May and June of this year as evidence, when the yield on the ten-year Treasury rose from about 1.60% to 2.60%, some claim that higher volatility in the bond market is a “new normal” that is here to stay due to the absence of such an important role player.Whether the market is forever broken or simply in need of an adjustment is an argument I will leave to others, but with such an important factor coming up more and more in discussions about risk, I thought it would be useful to review the role liquidity risk plays in a securities portfolio.Liquidity can be defined several ways, but for this application I define liquidity as a measurement of the ease with which a particular bond is bought and sold with minimal price impact. Liquid bonds are easy to locate in the marketplace. Dealers are more willing to trade liquid bonds and reflect that sentiment in prices they are willing to buy and sell resulting in narrow bid/ask spreads. Liquidity varies greatly between sectors of the bond market and the level of liquidity in a bond portfolio can affect performance even if there is very little buying and selling of securities. Like most investment risk, liquidity should be managed carefully but can be used to meet performance goals.From an investor’s perspective, liquidity should be thought of as a risk factor. All else constant, an investor would prefer to hold liquid bonds over illiquid bonds, so investors must demand higher rates of return in exchange for liquidity risk. Just like other risk factors such as credit risk and term risk, the added risk cannot be justified without added compensation.So what bonds are we talking about exactly?Like most things in Bondland, it all starts with US Treasuries. The US Treasury market is the most sophisticated and liquid bond market in the world. In fact, benchmark on-the-run Treasury bonds are more liquid than many parts of the US stock market. In normal operating markets, bid/ask spreads for Treasury bonds are measured in thousandths of a percent of par, or just a couple cents per $1,000. Trade execution in the Treasury bond market is so efficient that there is virtually no compensation for liquidity risk.Compared to Treasury bonds, government agency bonds carry a very similar credit profile, but typically have slightly higher yields due in part to liquidity risk. For benchmark agency bullets this typically ranges from 10 to 20 basis points in yield. For non-benchmark bullets and callable issues the liquidity premium is a little wider. Issue sizes are smaller and the market is a bit more fragmented for these types of agency bonds so the secondary market is little less liquid.Corporate bonds follow the same template as agency bonds. Large benchmark issues from very well-known high quality issuers are very liquid, but as you move toward issues with more complicated option features or non-investment grade credit ratings liquidity is a little harder to come by.As you move to more esoteric segments of the bond market, liquidity can dramatically worsen. Liquidity in the mortgage backed securities market ranges from extremely liquid current coupon TBA eligible agency pools to the very segmented and illiquid market for non-agency structured CMOs.Are you noticing a pattern here?It’s not quite as cut and dry as I make it out to be – thorough analysis should be done both pre- and post-purchase on the liquidity of different bonds in a portfolio. It should also be noted that liquidity for certain markets can change. For example – large defaults and other unexpected negative news in corporate and municipal bonds can send ripples through the market and hurt liquidity. Questions over the future of Fannie Mae and Freddie Mac hurt liquidity in the agency debenture and mortgage-backed securities market during the period of time before the two GSEs were placed into conservatorship. Comments from credit analyst Meredith Whitney calling for significant defaults in the municipal bond market caused liquidity in that market to dry up and yields to rise in late 2010.There are still other factors that can impact the liquidity of certain positions in a bond portfolio. Position size can have a sizeable impact on trade execution when you are looking to sell a bond from your portfolio. Smaller positions and older mortgage-backed positions that have paid down over time are likely to sell at a discount to the statement price. The time of day you try to do your trades as well as trading around holidays are other factors that can impact liquidity and can be managed to improve execution.The securities portfolio needs to be very liquid to offset the extreme illiquidity of the rest of a bank’s balance sheet. While investors can earn a little extra return by having some securities with less than ideal liquidity, it is certainly a risk that must be managed. An appropriate strategy allows the bank to meet deposit outflows and collateral needs as part of other funding arrangements, while still meeting performance goals.What’s important to realize is not every security is inherently liquid. Despite their being a secondary market for the bond, some securities are extremely illiquid. Furthermore, positions purchased as part of that core liquidity allocation are not guaranteed to remain as liquid throughout the entire life of the bond, so ongoing analysis is an important part of the due diligence process. And perhaps most importantly, after identifying your exposure to liquidity risk, make sure you are being compensated appropriately.About Cliff Reynolds Jr., CFACliff Reynolds Jr. is the Vice President, Bank Services Group at Acropolis Investment Management L.L.C., a St. Louis-based Registered Investment Advisor founded in 2002. Today, Acropolis manages more than $1 billion for private clients, institutions and retirement plans.