Illiquid assets

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GLOBAL INVESTOR 1.15 — 12 people chose not to sell them. But it is still a fact that their prices fell much less than those of more liquid stocks. Sid Browne: So would it make sense to have a very large exposure in your portfolio to these types of stocks? Roger Ibbotson: If you’re a day trader, you don’t want to buy these kinds of stocks because they’re going to have higher trading costs. It really depends on your horizon. If you have a longer horizon, then buying less liquid stocks can make sense. Oliver Adler: Could you discuss the parallels in the bond market, or segments of the bond market, in terms of what those liquidity or illiquidity premiums would look like there? Roger Ibbotson: Well, first of all, bond markets are in the fortunate position of having yields to maturity that you can actually see. You know that if the bond doesn’t default, you’re going to get a specific return in that particular currency. And you know it in advance. In the equity market, you can’t see the forward returns in the same way. You only see the result. And since returns themselves are very volatile, it’s hard to discern what the result really is. Moreover, the return measures differ strongly over different periods. That’s why we can debate which of these premiums really exist and how high they are. This is quite different in bond markets where maturities are normally fixed. Oliver Adler: Would you say that the stock market gives rise to more irrational behavior in some sense than the bond market? Roger Ibbotson: I’m sure there is irrational behavior in the bond market, too. But yes, there is behavior in the equity market where essentially people are attracted to stocks that trade a lot. And they’ll pay more for them, just as you would do with brands in the consumer market. Consequently, the return structure is going to be different among the less popular and the more popular, and that leads to mispricing. Of course, you’re also going to see mispricings in the bond market, but they may be smaller there and they’re more visible and thus easier to take advantage of. Sid Browne: You’re saying that something could be more popular in the equity market than it would be in the bond market. So Apple stock, for example, could go “hot” and very, very liquid, but the debt, because it’s traded less and because it is a discounted flow of more certain “What’s especially interesting in liquid markets is that giving up a little bit of liquidity actually can have a surprisingly big impact.” Roger Ibbotson cash payments, would actually not be impacted by this popularity phenomenon. Roger Ibbotson: It could be affected, but it would not be affected by as much because you can see the pricing exactly in a yield spread. And so you know exactly what you’re paying for. José Antonio Blanco: Are you saying that we have more serious information issues in the equity than in the bond market? If you compare two bonds, it’s relatively easy to find the one that is paying too much, or too little. Whereas, for a stock, you might look at the past, but the future is much more difficult to assert. So, as an investor, you tend to grab things that are a bit easier to recognize, like brand names, along the lines “if something is popular, it’s probably better.” Roger Ibbotson: Yes. In the equity markets, you can tell stories about the stock. And the stories can be very interesting. And you can pay a lot for stories. That’s why, for example, value tends to have higher returns than growth. Growth gets highly priced because growth companies have much more interesting stories than value companies. In the bond market, all these same phenomena may exist, but there is more information. It’s much more mathematical. The spreads are visible. Oliver Adler: How about areas like private equity, or hedge funds, where you need a lot of knowledge and can’t easily tell stories? Might it therefore be fair to say that mispricing phenomena occur less frequently here? Roger Ibbotson: Well, mispricing can be pretty frequent in private equity as well because there’s actually less information for the buyer. You need more specialized expertise to understand the specific stocks. Also, in private equity, the presumption is that the private equity manager not only identifies undervalued stocks, but actually changes the company in some way to make it more valuable, perhaps by getting tax benefits, restructuring management or altering incentives. So there are potentially more possibilities for profit if you’re really good at doing that. Hedge funds typically buy publically traded equities or bonds – more or less liquid securities. When you invest in a hedge fund, you are essentially buying the manager who is buying liquid securities. continued on page 14 >
GLOBAL INVESTOR 1.15 — 13 How Moody’s measures liquidity stress In periods of market stress, investor scrutiny often moves onto lower-rated financial instruments that have been issued with a premium yield level attached. Concerns about the ability of issuers to meet ongoing cash obligations for coupon payments can lead to investor flight from speculative bonds, just at the moment when those issuers most need to shore up their finances to remain in business. Classic examples might be riskier consumer finance companies, smaller oil and gas firms, and heavily leveraged property developers. If the stress period persists, such issuers are often unable to raise suffi cient short-term debt to maintain their trading activities and, if undercapitalized, they may even fail. Defaults in this riskier zone can prove contagious, both because of the effect on other parties exposed to a given sector or deal, and due to the psychological effect on the general investing public. A vicious illiquidity circle can develop, as occurred in real estate loans in 2008–2009, and may require government intervention and ultimately debt write-downs. Liquidity, a key element of credit analysis In order to provide additional transparency in its existing liquidity assessment process and arm investors willing to hold speculative- grade debt against falling foul of rapid shifts in market sentiment, the rating agency Moody’s began assigning Speculative Grade Liquidity (SGL) ratings in 2002. Loss of access to funding remains a risk criterion in any assessment. Defining speculative-grade liquidity risk as “the capacity to meet obligations,” SGLs describe an issuer’s intrinsic liquidity posi tion on a scale of 1 (very good) to 4 (weak). Assignment of a rating is carried out under detailed criteria for measuring a company’s ability to meet its cash obligations through cash, cash flow, committed sources of external cash, and potentially available options for raising emergency cash through asset sales. SGLs are a measure of issuers’ intrinsic liquidity risk – meaning Moody’s assumes companies do not have the ability to amend covenants in bank facilities or raise new cash that is not already committed. Such conditions are not typical in normal market environments, but can occur in periods of economic and credit market stress when companies need liquidity support the most to avoid default. Because Moody’s factors market access and the ability to amend covenants into its longterm ratings, the assumptions utilized in analyzing liquidity are more stringent. One proviso that Moody’s noted from the outset is that liquidity assessments focus on corporate capacity to meet obligations. Willingness to default remains a management issue that is not factored into SGL ratings, but is separately evaluated as part of the longterm ratings analysis. Ratings are dynamic and may be modified ad hoc, as with bond ratings. To date, Moody’s assigns SGL ratings to US and Canadian issuers alone, although the framework is used in most other regions as well. Moody’s maintains SGL ratings on appro ximately 840 issuers, with USD 1.8 trillion in rated debt. Index summarizes the market conditions Moody’s also created the Liquidity Stress Index (LSI) to provide a broad indication of speculative-grade liquidity. The LSI is the percentage of SGL issuers with the weakest (SGL-4) rating. Changes in corporate earnings, borrowing costs and ease of new debt issuance are critical drivers of changes in the LSI over time. Credit cycles tend to lead the economic cycle because willingness to leverage into expanding economic activity has to occur before the activity itself gets underway in the real economy. Speculative-grade companies do not have access to the commercial paper markets, so they are generally unable to quickly raise new financing in crisis moments. Measuring their riskiness essentially boils down to gauging the free cash flow from operations, cash on hand, and committed financing from other sources such as revolving credit facilities (the latter is not part of the SGL analysis.) More than 12 years after the introduction of SGLs, the track record now includes both extended periods of more-than-ample liquidity and phases of unprecedented risk and market stress. The LSI’s long-term average value since inception is 6.8%, with a record high reading of 20.9% in March 2009 at the height of the financial crisis in the US. The lowest level reached by the index was 2.8% in April 2013, with default and illiquidity risks exceptionally low. At the start of 2015, the index was still very benign at 3.7%, indicating a below-average forecast of the default rate of speculative-grade companies in the course of this year. Higher risks from falling oil prices were balanced against the steady earnings gains from US consumer spending. Article by John Puchalla, Senior Vice President, Corporate Finance Group at Moody’s Co-Author Gregory Fleming Senior Analyst +41 44 334 78 93 gregory.fleming@credit-suisse.com
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