By C. Hunter Downs, DoubleLine Capital LP
(DoubleLine is the subadvisor to the ASTON/DoubleLine Core Plus Fixed Income Fund)
Bond market liquidity was historically high before the credit crisis in 2008. Massive dealer positions and excessive risk-taking from leveraged dealer balance sheets, however, have been systematically reduced in recent years due to increased regulation, including limitations imposed by Dodd-Frank legislation. These limitations have reduced dealer inventory size and proprietary trading as banks are required to have higher capital ratios and better leverage standards. As a result, market depth and liquidity have fallen. So what does this mean for investors?
DoubleLine believes that unlevered dealer balance sheets will reduce the impact of any future financial crises, leading to more garden-variety market corrections in the bond market. The asset management industry is taking on the larger role of financial intermediary due to tighter regulations on banks, rising compliance costs, and continued bank balance sheet deleveraging. Therefore, it is more important than ever to assess how managers manage liquidity risk, including liquidity mismatch factors.
Avoiding Liquidity Traps
Historically, DoubleLine’s strategies have not been highly reliant on liquidity. Rather, we try to take advantage of opportunities that arise by having the ability to invest more, at lower prices, when liquidity is scarce. High-volatility, high-frequency investment strategies are typically most vulnerable to episodes of market illiquidity, sometimes referred to as “liquidity traps.” Such strategies represent the antithesis of DoubleLine's historical approach to investment management. We seek to maintain low turnover in our portfolios and have less buying and selling activity than most other fixed-income managers as measured by relative turnover calculations. No manager is immune to bouts of illiquidity, but with the right portfolio construction and investment approach, it is possible to take advantage of such periods rather than just endure them. Our aim is to buy assets, hopefully at prices below durable intrinsic values, which can then be held to maturity even if prices fall or price discovery ceases to take place.
At DoubleLine, we bear in mind the under-appreciated fact that liquidity is ephemeral. Liquidity is typically dependent on which way you want to trade versus the consensus. Usually, as a holder’s desire to sell an asset increases, their ability to sell decreases as the out-of-favor sector falls in price. Thus, securities tend to be liquid when you don’t need liquidity and illiquid when you do need it. We try to balance our portfolios with a healthy dose of government or government-sponsored securities and cash, assets that have historically remained in demand as liquidity in other sectors dries up. Such barbell portfolio structures allow us to buffer volatility using cash and government securities on one hand, while allocating to more credit-sensitive securities on the other. Having this portfolio construction in place beforehand allows for optionality if market liquidations occur that potentially give rise to buying opportunities.
At times, we have also found that we can benefit from portfolio liquidity during periods of volatility in order to service shareholder redemptions. We generally believe it's sensible to hold some true cash in the portfolio as a buffer rather than “cash proxies” like short-term securities or derivatives which embed counterparty risk. As such, the effects of liquidity mismatches and the effects of fund flows can be cushioned by product liquidity risk management.
DoubleLine’s portfolio managers have worked together for more than 17 years on average. They have experienced several market cycles, including periods of illiquidity. Today, illiquidity is synonymous with reduced dealer inventory positions and negative net issuance for sovereign debt overseas after European Central Bank purchases during the first quarter of 2015. We think DoubleLine’s strategies are benefiting, on a relative basis, from the current reduction in liquidity in the bond market because of our practice of looking for periods where you get paid to be a liquidity provider, as we have the wherewithal to do that. Ensuring that investment vehicle structures and leverage arrangements will permit a long-term approach to investing are ways we try to best prepare for bouts of illiquidity.
The information contained in this article is provided by DoubleLine Capital LP. (“DoubleLine”), a subadviser engaged by Aston Asset Management, LLC (“Aston”). DoubleLine is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and DoubleLine’s views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.