Every serious municipal investor is aware of the dire situation in Puerto Rico that existed in 2013 and 2014.

Municipal analysts and other market participants have spoken at length regarding the merits (or lack thereof) of the island as an investment. In addition, there has been seemingly no limit to the time spent and ink wasted discussing the possibility of what future monetary policy will be like. Very little, however, has been written about the liquidity risk facing the market and potential ramifications for municipal investors.

Liquidity in the municipal bond market is unique in relation to that of other asset classes. Unlike the equity markets, where on any given day an investor can punch in the ticker symbol of a favorite stock and buy any amount at the current market price, municipal bonds don’t have a quoted price. Whether they are held in a mutual fund or an individual portfolio, bonds are valued using an “estimated price” that is typically derived from trading history and other municipal-market data.

Liquidity risk arises as money leaves municipal mutual funds or the municipal market as a whole. As investors pull money out, funds are forced to liquidate their bonds to produce cash. If the bonds in the portfolio are illiquid, the fund may ultimately be required to sell the bonds at a price lower than the estimated valuation, adversely affecting portfolio performance. The same holds true for any individual investor who needs to generate cash from a portfolio.

Measuring Liquidity in the Municipal Market

Before delving into how a municipal investor should manage liquidity risk, it is important to understand how to measure potential liquidity. The most important measurement of liquidity in any market is the bid-ask spread (the difference in price between the highest price a buyer is willing to pay and the lowest price in which a seller is willing to sell). The wider the bid-ask spread, the more likely it is that an investor will be forced to sell below the estimated value.

Unfortunately for individual investors, it is often difficult to obtain information on bid-ask spreads. This lack of information has led to alternate methods of measuring liquidity that use more readily available data. Although these alternate methods do not directly measure liquidity, the results serve as something of a proxy for the bid-ask spread. For example, in the equity markets an analysis of liquidity will often focus on trading volume and frequency. A stock that trades frequently and “in size” is considered liquid. Stocks exhibiting those trading characteristics will generally have narrow bid-ask spreads.

A similar analysis is inappropriate in the municipal market. Trading volume in the municipal market is insufficient (both in size and frequency) and does not accurately reflect the bid-ask spread for a given bond. In 2004 and 2012, the Securities and Exchange Commission (SEC) undertook studies of municipal liquidity and trading patterns with several interesting findings:

• About 70% of municipal issuers had no trades in their securities in the period between December 12, 1999, and November 5, 2000. Less than 1% of securities accounted for half of overall muni-market transaction activity during this period.
• The unique municipal bonds that do trade, trade on average 1.5 times per year, according to the 2004 SEC “Report on Transactions in Municipal Securities” (July 1, 2004).
• The municipal-securities market is characterized by relatively low liquidity; following the initial distribution period, municipal securities trade only infrequently. For example, in 2011, about 99% of outstanding municipal securities did not trade on any given day, according to the 2012 SEC “Report on the Municipal Securities Market” (July 31, 2012).

Based on the SEC findings, it is clear that relying exclusively on the trade history of municipal bonds, or by association on the estimated values, as a proxy for liquidity—would be misleading and inaccurate. To sufficiently measure and protect against liquidity risk in a municipal bond portfolio requires a more sophisticated, multifaceted approach.

Financial Regulation and Its Impact on Municipal Liquidity

Liquidity risk in the municipal market has been further exacerbated by the implementation of the Dodd-Frank Wall Street Reform Act, the Consumer Protection Act, and other related financial reforms. During past periods of disruption in the municipal market, the large investment banks would typically step in and create a price floor, effectively operating as “buyers of last resort.” The banks’ participation largely mitigated the downside pricing risk for funds that needed to raise cash to meet redemptions.

Since the implementation of the Dodd-Frank act, those financial institutions have been forced to shrink their balance sheets, reducing their demand for municipal paper. Investors experienced this phenomenon to some degree in June of 2013. Following the announcement by Ben Bernanke that the Federal Reserve would consider tapering its quantitative easing program, the bond market froze. Most large banks exited or dramatically reduced their participation in the market. Luckily, the panic was short-lived and the market righted itself within a few days.

Bank participation is on pace to shrink even further based on the Federal Reserve’s recent decision to leave municipal bonds off of its approved list of high-quality liquid assets (HQLAs). Federal regulators have instituted rules requiring banks to maintain a minimum liquidity coverage ratio of HQLAs to net cash outflows. If municipal bonds fail to meet HQLA criteria, banks will prove far less likely to hold them and will favor assets that will keep them in compliance with the new regulations, further impinging overall municipal-market liquidity.

Characteristics of Liquid and Illiquid Municipal Bonds

Typically, illiquid bonds have several characteristics in common. They tend to be lower-rated credits from smaller-sized deals. Liquidity is stronger for issuers that frequently access the market since there is more recent and frequent trading history. More frequent trading leads to better estimated values, thus better estimates of a portfolio’s actual value.

To ensure liquidity, investors should focus on several aspects: the overall structure of the portfolio, the credit quality of the bonds in the portfolio and continuous scrutiny of the estimated value of the bonds in the portfolio to ensure reasonableness. Position sizes and diversification also play a large role in overall liquidity of a portfolio.

A Laddered Portfolio and Liquidity

Laddering fixed-income portfolios involves investing in bonds with staggered maturities so that a portion of the portfolio will mature each year. Laddering tends to perform well against other bond strategies over the long term because it simultaneously accomplishes two goals:

• Captures price appreciation as the bonds age and their remaining life shortens, and
• Reinvests principal from maturing bonds (low-yielding bonds) into new longer-term, higher-yielding bonds.

Laddering also provides natural liquidity. As bonds mature, the cash generated can be reinvested or used to meet the liquidity needs of the investor. Without the constant influx of cash to the portfolio, investors could be forced to sell bonds to generate cash. If the market is facing any type of liquidity distress, those investors could be forced to sell at distressed prices.

Credit Quality and Liquidity

While the laddered structure provides a steady stream of liquidity, it’s not necessarily passive. To the contrary, it can be highly actively managed. Indeed, bond investors should closely monitor the overall credit quality of the portfolios. While not 100% correlated, credit quality can play a large role in the overall marketability of a bond.

It should be cautioned that credit ratings alone do not in and of themselves drive liquidity. Much more important than a rating is the fundamental credit quality of the issuer. Bonds with strong legal provisions protecting their revenue streams will typically be more liquid than bonds with weaker protections, regardless of rating. The State of California is an excellent example. Despite a certain amount of media hype, California general obligation (GO) bonds have virtually no credit risk due to their strong legal protections. Although they are only rated A+ by S&P, California GO’s are every bit as liquid as most AAA-rated issuers.

Investors with higher risk tolerances may be drawn to lower-rated credits. In those instances, investors must ensure that they are being adequately compensated for the risks they are taking. That compensation must include a premium for the decreased liquidity of those bonds. To make that determination, investors should focus on credit spreads in the market. Credit spread is the incremental yield an investor receives for investing in a BBB-rated bond as opposed to a AAA-rated bond. Investors should ensure that the credit spreads are sufficiently wide when purchasing lower-grade municipal bonds.

Mutual Funds versus Individual Ownership

Fixed-income investors have a choice between investing in mutual funds and opening individual accounts in which they actually own the underlying securities. There are benefits to both approaches that need to be weighed based on an individual’s specific needs.

In general, from a liquidity standpoint, mutual funds tend to be a better option than separate accounts, with one notable exception. Mutual funds are priced every night. As such, investors do not need to worry about the liquidity, or lack thereof, of any individual bonds. Shares can be bought and sold every day at the fund’s net asset value (NAV). Obviously, if the fund were forced to liquidate a large portion of its holdings in a short amount of time, any liquidity issues they faced would be reflected by declines in the net asset value. Also, mutual funds should be analyzing the estimated value on all of their positions on a daily basis to ensure that bonds are accurately priced.

In addition, mutual funds typically hold larger positions in each security, while remaining more diversified. The increased diversification protects the liquidity of the funds from any unforeseen change in demand for a particular type of bond. Investors who were heavily weighted in any type of Puerto Rico paper have been punished as the bid on those bonds disappeared. Position size comes into play as odd lots (less than $1 million) trade much less favorably relative to block-sized positions. Mutual funds, due to their size, have the ability to trade in larger denominations, which greatly lower the bid-ask spread. Generally, individual investors are forced to incur the liquidity penalty associated with trading in the odd-lot space.

Lastly, mutual funds provide professional management, which should include detailed credit work and the best possible trade execution. Most individual investors are not equipped to perform the rigorous credit work required to accurately judge the merits of an issuer. Additionally, they may lack the skill and resources necessary to ensure that bonds are being purchased at a price that adequately compensates them for all types of risk.

Owning individual bonds provides one advantage, specifically geared to the buy-and-hold investor. Assuming that there is no credit default, bonds mature at par. An investor participating in the municipal market with no current cash needs can simply wait out any market disruptions, whereas a mutual fund investor would be subject to any impact that liquidity issues would have on the fund’s net asset value. This caveat assumes that the investor has other sources of liquidity, or will have no liquidity needs for the life of the bond.

Conclusion

The dynamics of 2014 being a banner year for municipal bonds, with low supply and high demand, has led to investor complacency as I write this. Just because liquidity isn’t currently a risk in the market doesn’t mean tomorrow won’t bring liquidity issues. This is particularly true in a market environment characterized by several individual credit stories as well as interest rate increases.

The discussion of liquidity isn’t as riveting as the debates over the bonds issued by a particular state or U.S. territory or debates about potential forthcoming macroeconomic risks, but the ramifications of a liquidity event could be every bit as painful for investors.

Related

Bonds

Bond Strategies for Those Fearful of Inflation

Related

Bonds

How to Buy Individual Bonds: A Fixed-Income Toolkit