Liquidity woes could offer deals for patient investors

A year into the credit crisis, the lack of liquidity in many market segments might hold long-term opportunities for money managers willing to sift through the mound of depressed investments.

As cash-strapped Wall Street firms curtail principal trading, speculators think twice about the cost of funding positions and traditional investors shy from risk, liquidity has dwindled in credit markets, driving spreads wider and prices to bargain-basement levels.

For instance, high-yield debt spreads rose 175 basis points since May, to 812 basis points, more than three times the all-time low of 241 basis points set in June 2007, according to the Merrill Lynch & Co. High-Yield Master index.

The lack of liquidity creates a punishing environment for those who need to exit the market in a hurry, but it also holds potential rewards for those armed with cash, patience and a good sense for fundamental analysis.

“Cash is king in this market. But you have to be willing to spend it when you see an opportunity,” Zane Brown, principal and fixed-income strategist at Lord Abbett & Co., said in an interview.

He also stressed the importance of knowing the fundamentals when looking for bargains. As an example, Mr. Brown said his Jersey City, N.J., firm, which has $100 billion in assets under management, recently bought municipal debt at a good discount because the holder of the high-quality securities needed to quickly raise capital to buy a new issuance.

“Liquidity is one of the factors that drive the investment style. If we get involved in a transaction, liquidity is always an important issue,” Mr. Brown said. He noted that some parts of the credit market, currently hurt by a dearth of liquidity, involve large spreads that will look very rewarding once the financial storm passes.

“You have broad differences in high-quality vs. low-quality securities. But that, too, will change and return to a narrower differential,” he predicted.

A good indicator of liquidity in a debt market is investors' appetite for new issuance.

For the year to date through Aug. 8, U.S. issuance of high-yield corporate bonds plummeted 61%, to $35.8 billion, vs. the same period in 2007, while issuance of investment-grade bonds was down 15%, to $457 billion, according to data provided by analytics and consulting firm Dealogic, New York.

The volume of new asset-backed securities dropped 79%, to $123.1 billion, over the same period. Mortgage-backed debt issues have plunged amid the deepening housing crisis — commercial mortgage-backed securities collapsed 97%, to $5.2 billion, while residential mortgage-backed paper fell 77%, to $126.9 billion.

“There is a relation between the liquidity in a given market and the issuance of new paper,” said David Resler, chief economist at Nomura Securities International Inc., New York. “If there is nobody willing to buy the paper, there is no point in trying to issue it.”

The now-infamous collateralized debt obligation market has come to a standstill, down 93% year to date through Aug. 8.

Liquidity — or the lack of it — is an important factor in the bid-ask spread in government, corporate and municipal bond markets, according to “Liquidity in U.S. Fixed-Income Markets,” a research paper by Sugato Chakravarty, professor of finance at Purdue University in West Lafayette, Ind.

“Liquidity matters simply because greater liquidity implies lower cost of trading. And institutions are extremely sensitive to liquidity because they trade in large quantities, and every bit of cost saving adds up to a sizable amount,” said Mr. Chakravarty in an interview.

“Some markets are more sensitive to liquidity crunches than other markets. Typically, the fixed-income markets are an example of a market that is not as transparent as the equity market,” Mr. Chakravarty further noted.

Market participants think that cash is not in short supply, but it remains on the sidelines as the investing community seeks evidence that the storm has truly passed. Their sentiment is that once the negative headlines abate and investors no longer wait for the next shoe to drop, liquidity will come back and reward those who went back to the distressed markets early.

“Liquidity is both the cause and effect of decisions that managers make. The relative lack of liquidity is one of the reasons a lot of market participants are more fearful of the markets, and that's one of the reasons there is less liquidity,” said Ty Anderson, global head of high-yield strategies at DB Advisors, New York, the money management arm of Deutsche Bank AG, which has $367 billion in assets under management invested in fixed income.

“The whole issue of liquidity becomes circular because liquidity fears feed on themselves. The lack of liquidity makes it more difficult to make strategic decisions. It tends to amplify the short-term volatility of the market, which increases the fear factor. It highlights the interrelation between fear and greed,” Mr. Anderson said.

Broker-dealers, which traditionally make markets in a number of asset classes to keep liquidity flowing, have reduced their presence, which, in turn, discourages other market participants.

“The fact that broker-dealers are putting less capital to work on their trading desks has, without question, an impact on short-term liquidity in the market. That's very clear,” said Mr. Anderson, who looks at issuers' fundamentals when bargain hunting.

“There are BB-rated issues in the high-yield space that have been beaten down because the dealer has not been putting enough money in the market,” he said.

Some markets are faring better than others when it comes to liquidity. “Right now, the convertibles market is more liquid than the high-yield market. It's one of the few markets that is still open today,” said Tracy Maitland, president of Advent Capital Management LLC, New York, which has $4.2 billion in assets under management.

Mr. Maitland pointed to opportunities in that market, citing the -7.18% return of the Merrill Lynch All Convertibles index for the first seven months of 2008 vs. -12.65% for the S&P 500 index.

Bear Stearns Cos. Inc.'s fall and balance sheet troubles at Lehman Brothers Holdings Inc., New York, also have affected regulated markets, such as the interest rate listings on CME Group Inc., Chicago.

As market participants are less involved in the dealer-driven credit markets, they have fewer positions to hedge in futures. Open interest, the main gauge of future trading activity, showed a dramatic drop in July vs. the same month in 2007. The volume for open interest on CME interest-rate futures was down 17.3% in July vs. July 2007, and options on interest-rate futures declined 36.3% for the same period.

Open interest for eurodollar futures, the CME'S flagship listing, dropped 15.4% in July vs. a year earlier, and volume for options on those futures contracts was off 38.8%.

“Credit issues, manifesting in elevated LIBOR-OIS spreads, are hurting eurodollar volumes,” said analyst Christopher Allen at Banc of America Securities LLC, New York, who expected the trend to continue, due to economic uncertainty.

In the absence of abundant liquidity and eagerness to lend, the spread between LIBOR, or the London interbank offered rate for dollar lending, and the OIS, or overnight indexed swap rate, currently fluctuates above 75 basis points — or almost seven times its historical level.

In the long run, such levels in that market and other credit segments are not sustainable. For investors focused on fundamentals, the reward could be significant, once the credit markets return to more normal levels.

Contact Isabelle Clary at [email protected]