Reduced fixed-income liquidity forcing managers, assets owners to look for new sources

Money managers and asset owners like pension funds are looking to illiquid and liquid options to counteract what's become the new normal among institutional investment — reduced liquidity in the fixed-income market.

“There's reduced liquidity as a consequence of banks and other actors stepping out, but we're now seeing more hedge funds and other actors providing liquidity in markets like credit,” said Thomas Kehoe, director, global head of research, Alternative Investment Management Association, London. “We're also seeing that more recently in the equity space through the use of securities lending, repos (repurchase agreements) and swaps. Alternative actors are playing a greater role.”

The shift comes at a time when almost half of institutional investors believe decreased liquidity is here to stay. According to a report by State Street Corp., Boston, and the AIMA, 48% of asset owners, investment managers and hedge fund managers said reduced liquidity will be a long-term issue in securities markets.

Also, 30% of survey respondents said their investment portfolios have been less liquid over the past three years, according to a report by the AIMA and State Street, “Let's Talk Liquidity: Opportunities in a New Market Environment.”

Other survey results regarding investment portfolios were:

• 34% of asset owners and 29% of managers and hedge funds will consider increasing their high-yield allocations for higher returns.

• 61% of hedge funds will increase the use of illiquid investments for higher returns, vs. 50% of asset owners and 37% of managers.

• 44% of all respondents will increase the size of their cash allocations against future liabilities and redemptions.

“While some institutional asset owners and managers plan to place increased emphasis on liquid assets, others will opportunistically allocate more to fast-growing illiquid asset classes,” the report said.

The AIMA's Mr. Kehoe said pension funds' dual needs of managing deficits and seeking higher returns are what makes liquid and illiquid options important to them. “They need to manage whatever deficit they have in relation to their returns, so they need to take advantage of both liquid and illiquid opportunities,” Mr. Kehoe said. “In doing that, they need to be aware of the liability structure of their plans and how their investment strategies meet their liquidity needs. We're seeing more of that.”

Mr. Kehoe cited three reasons for pension funds' moves:

• A dearth of yield opportunities in fixed income and credit, traditional sources of liquidity, is forcing investors to find alternate liquidity sources.

• Hedge fund strategies aligned to credit are doing better than the average credit investment in fixed income.

• Regulatory changes that make it more costly for traditional market makers like banks and broker-dealers to hold inventory have spurred the use of other liquidity sources — mainly hedge funds, but also electronic market makers like dark pools and, potentially, large pension funds.

According to the State Street-AIMA report, 43% of hedge funds said they would replace banks and other traditional market makers as liquidity providers, vs. 35% of asset owners and 16% of money managers. In addition, 49% of all respondents said they think the use of non-bank institutions to provide liquidity will grow, and 42% believe the use of hedge funds as liquidity providers will grow.

Paul Fleming, executive vice president, global head of hedge fund asset servicing at State Street, said that the move away from intermediary banks has created a “new reality” for other potential liquidity providers. “This will create new opportunities for other providers, including smaller businesses.”

Mark McKeon, senior vice president, global head of investment analytics, State Street Global Exchange, Dublin, said the liquidity needs of asset owners differ from those of money managers. “Asset owners are not under as much pressure as managers when it comes to liquidity,” Mr. McKeon said. “That's because asset owners have a longer-term view of their investments than do money managers, particularly those in the retail space.”

Still, that doesn't mean asset owners don't take a close look at liquidity — particularly with their illiquid investments. “A lot of pension funds measure the liquidity of funds independently,” Mr. McKeon said. “They want to know whether the funds in which they invest can meet those terms. Can asset owners get their money back in times of stress, and if so, how quickly?”

The State Street-AIMA report is based on a global survey of 150 asset owners, 100 money managers and 50 hedge funds in June and July. The full report is available on State Street's website.