fixed income
Managing liquidity risk in Swiss bond portfolios
Swiss bonds are categorised as a liquid asset class. The funds can generally be traded daily, allowing for tactical management of investment risks in a strategy. That is in contrast to illiquid asset classes, which are not suitable for such maneuvers. Swiss bonds also offer very good and diverse risk/return characteristics. Still, they should not be seen as a substitute for cash. Depending on the respective bond segment, average bid-ask spreads of more than 20 basis points should be expected – so there is certainly a cost involved in managing CHF-denominated bond portfolios.
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A dynamic parameter
The liquidity of an investment essentially means how quickly a usual volume of it can be bought or sold on the market without affecting the price. For the CHF bond market, liquidity is not a static parameter, but rather a dynamic one. For example, while good-quality bonds with a remaining maturity of less than five years can generally be sold very easily, it was almost impossible to find buyers for such securities during the pandemic.
It is vital that bond investors be able to estimate how much liquidity risk is priced into the observable credit risk premium based on a sound credit analysis. In the event of a significant widening of the premium, it should be possible to assess whether it stems from a drop in liquidity or an increase in credit or default risk.
If the widening is liquidity-related, it is usually worth sitting out the situation and, if possible, even actively profiting from the future recovery. If the higher credit risk premiums are significantly related to default risk, it is better to consider selling regardless of the price.
Market characteristics
The CHF bond market is a good CHF 600 billion in size and dominated by high-quality borrowers, such as the Swiss Confederation, the Pfandbriefzentrale and the Pfandbriefbank1. High-quality borrowers with AAA and AA ratings account for around three quarters of the total market. The remainder have lower ratings, although they are still mainly investment grade. The average daily trading volume on the CHF bond market is around CHF 500 million. The majority (more than 80%) is traded via brokers, rather than via the SIX exchange.
The typical CHF bond investor tends to have a longer investment horizon and keeps the bonds in their portfolio for a correspondingly long time. This applies in particular to insurance companies that tend to focus on asset and liability management (ALM) and the providers of passive solutions that still dominate the market.
However, because the benchmark universe is adjusted monthly, passive bond solutions also have a comparatively high turnover. Insurance companies and treasurers are normally less focused on a benchmark and invest more situationally and opportunistically. This clear segmentation of investors on the CHF bond market means that price distortions can occur time and again. This is precisely why the CHF bond market is predestined for active investment approaches. However, active solutions require, among other things, the ability and capacity to bear and adequately manage liquidity risks.
How to measure liquidity
The most reliable way to assess a bond’s liquidity is by recording the daily traded volume in a database. This shows which bonds have been traded particularly often or with a higher volume. Of course, there is no guarantee that these patterns will persist, but it offers a valuable indication of the segments where the market is offering more liquidity.
The conventional wisdom is that good-quality borrowers are the most liquid. This is only partially true, as liquidity is determined more by the outstanding bond volume and the term of the bond. The larger and shorter the bond, the better the liquidity. In principle, it also helps if the same borrower has several bonds with a larger volume outstanding on the market. A large BBB bond (e.g., from VW1) with a term of less than five years may well be more liquid in a normal market environment than a Swiss Confederation bond with a term of more than 20 years.
Many market participants are also inclined to estimate liquidity using the bid-ask spread. The tighter the spread, the better the liquidity. The difficulty in this case arises from the fact that the bid-ask spread can usually only be read on the stock exchange. As already mentioned, only a small proportion of CHF bonds are traded on the Swiss stock exchange. The spreads quoted therefore often apply to relatively small trading volumes (often less than CHF 100,000). This gives an incomplete picture of current liquidity.
How to deal with liquidity
It is therefore vital for institutional investors in particular to have good market access, with a broad network of key trading partners. If you have your own broad product range, you can also benefit from cross trade opportunities in some situations. This refers to transactions between proprietary products, which are usually executed at mid-price after authorisation from the compliance department. For example, a bond fund can transfer its shorter bonds to the money market fund, thus obtaining a better price than if it sold them on the market. Conversely, the money market fund benefits from a lower purchase price.
As a provider of fund solutions, you want a good distribution of investor types and investment sizes. It is essential that investors are informed proactively, openly and consistently at all times. Before purchasing the product, investors should be aware of the investment process and the interest rate and credit risks of the product, and also be given a clear idea of the liquidity risks.
In the event of a crisis situation such as Covid, it is crucial to proactively inform investors and clarify whether the widening of credit risk premiums is liquidity-related or more driven by default risk. This can help to avoid unnecessary and costly transactions. A good and open dialogue with the client usually also keeps you aware of major adjustments to your investment strategy with corresponding cash flows. This in turn helps you to make the necessary adjustments to the portfolio at an early stage.
Diversification
Large, well-diversified investment vehicles are generally easier for managing cash outflows and inflows because the influence on the vehicle is smaller. A subscription of CHF 50 million in a CHF 200 million fund, for example, causes greater adjustments than the same subscription in a CHF 1 billion fund.
To protect existing investors from the costs incurred for subscriptions and redemptions, many products use a subscription or redemption fee. The central idea behind these fees is that the investor who makes the move should pay the costs incurred, and existing investors are not charged. Bond funds that claim to have no subscription and redemption fees using the single swing pricing methodology also protect their existing investors by swinging the NAV. Investors who subscribe to the fund usually cannot buy in at NAV and have to pay a higher, upwardly swung NAV. On the other hand, investors who withdraw their money receive a lower, downward-sloping NAV.
Ultimately, when investing new money, even with active solutions, ensuring good diversification across debtors and bonds minimises liquidity risks. If a specific debtor is to be overweighted, it may make sense, for example, to realise the overweight via several bonds of the debtor with a view to the liquidity risk. This reduces the chance that, in the event of an unexpected outflow of funds, you are invested in the bond with no liquidity and end up penalised with large price discounts when selling.
In conclusion, CHF bond portfolios are always exposed to certain liquidity risks despite daily tradability. However, those who are able to take and adequately manage liquidity risks in a Swiss bond portfolio can benefit from the resulting opportunities and an additional liquidity premium in the medium to long term.
The key to the professional management of liquidity risks lies in detailed and well-founded credit risk analysis. Our credit analysts fully integrate the liquidity assessment into their comprehensive fundamental analysis of the issuer, which is particularly important for actively managed products.
