David shared a copy of his quarterly shareholder letter with me earlier this week. It's
posted on the RiverPark site now and it's worth reading.
I came away from it with two strong impressions:
there may be emerging structural problems in the investment-grade fixed-income market. At base, the unintended consequences of well-intended reforms may be draining liquidity from the market (the market makers have dramatically less cash and less skin in the game than they once did) and making it hard to market large fixed-income sales. An immediate manifestation is the problem in getting large bond issuances sold, a potential problem might be the emergence of a roach motel issue if things get rocky. That is, it might be easy to get in but impossible to get out of some safe issues.
Mr. Sherman is very cognizant of the need to have portfolios that could ride out a storm without the need to liquidate holdings; better than half of RPHYX will roll off to cash with 60 days and a quarter of RSIVX is invested in the same securities as RPHYX is. His argument is that given the challenges facing large bond issues, you really want a fund that can benefit from small bond issues. That means a small fund with commitments to looking beyond the investment-grade universe and to closing before size becomes a hindrance.
Some of his concerns are echoed on a news site tailored for portfolio managers, ninetwentynine.com. An article entitled "Have managers lost sight of liquidity risk?" argues:
A liquidity drought in the bond space is a real concern if the Fed starts raising rates, but as the Fed pushes off the expected date of its first hike, some managers may be losing sight of that danger. That’s according to Fed officials, who argue that if a rate hike catches too many managers off their feet, the least they can expect is a taper tantrum similar to 2013, reports Reuters. The worst-case-scenario is a full-blown liquidity crisis.
The article goes on to express concern that holding elevated cash levels is a poor response since panicked withdrawals could quickly exhaust even an elevated cash stash (see 'Total Return Fund, PIMCO" for details), leaving managers "out of both cash and choices." The better solution, they argue, is building "organic liquidity" into the portfolio. Which, I believe, is what Mr. Sherman has done.
Hope your weekend has started well. It's cold and rainy here, which is keeping me out of the garden and close to the keyboard.
David
Comments
Here is a post from Baird along the same lines (from February).
http://www.bairdfunds.com/news/changes-to-bond-markets-create-liquidity-concerns-and-systematic-issures-bond-investors-should-consider
Edit: Driehaus shared concerns about "The Evolving Liquidity Crisis in the Bond Market" in their February commentary of LCMAX
http://driehauscapitalmanagement.com/pdf/funds/summaries/lcmax-summary-22815.pdf
"Here’s what we’ve done over the past several years to address our concerns about declining market liquidity:
• We continue to hold high cash balances, typically 8% to 20% of AUM, in all of our portfolios.
• When we initiate new positions in the portfolios, we’ve reduced the percentage of a bond issue that we are willing to hold. A year or two ago, we were comfortable holding up to 15% of any bond issue. Now, we prefer not to hold more than 10% of any given issue.
• We model 2-10 points of additional downside in our bear case scenarios ....
• If a bond is a large component of a major etf, we require additional risk premium to own the bond ....
• We are quicker to recognize and hedge downside volatility when liquidity declines, as compared to prior years.
• We consider equity as an investment option in the capital structure more frequently than in the past.
• Finally, we have soft closed strategies well below fund capacities to alleviate liquidity-related stress on existing positions."
The level of perceived risk would seem to depend to some degree on the macro outlook, i.e., a rates-takeoff vs. a lower-for-longer view.