The expert magazine of Ostrum AM

Ever a source of uncertainty for investors, liquidity risk is an important factor to take into account during portfolio construction. Low liquidity can, however, be a source of improved yield for long-term investors with no day-to-day requirements in terms of liquidity.

Portfolio managers must take into account the impact liquidity has on pricing and transaction costs when making investment decisions

Our approach

We aim to demonstrate the relevance of a combined approach that relies on both ‘smart beta’ strategies (alternative benchmarking and portfolio construction) and active management that capitalises on the convictions of our asset managers.

 

ABSTRACT

  • Liquidity risks are a major source of uncertainty that affect a portfolio’s future gains or losses.
  • Liquidity is a risk factor that makes it possible to anticipate returns ex-ante (prior to events)  and explains performance ex-post (after).
  • Liquidity diminishes with position size. This phenomenon is seen in the short term, but disappears over the long term. A security held to maturity generally carries no liquidity risk.        
  • Liquidity metrics applicable to stocks are not suited to the bond market, where metrics must take into account a bond’s intrinsic properties. For instance, a measure of liquidity based on trading volume could be misleading, as traded bonds are not guaranteed to be liquid. Conversely, an untraded bond is not necessarily illiquid.
  • Liquidity risks are not of the sort that can be hedged. It is not possible to offset exposure to liquidity by shorting an illiquid security . No liquidity-based derivative as yet known can cover this specific risk.
  • Illiquidity can generate surplus yields for long-term investors who can dispense with liquidity on a day-to-day basis. When making investment decisions, portfolio managers must take into account the impact liquidity has on pricing and transaction costs.
  • Ignoring liquidity risks can lead to underestimation of the one-week VaR (99% confidence) of a bond portfolio by 22%. This estimation gap decreases with increasing VaR horizon, but never disappears. Source: Ostrum AM précédemment Natixis AM - 2014.

 

Liquidity Risk in the Bond Markets

Download Read the research paper in full