Bond investors have historically enhanced their returns by taking on more interest rate or credit risk. Today a third opportunity is emerging: the liquidity premium.
As investors search for new ways to earn income in a low-interest-rate environment, there are more and more illiquid investment opportunities. These investments may not be as readily tradable as others in the fixed-income world. But they do provide investors with a healthy yield premium in exchange for giving up the ability to quickly convert their assets to cash.
What market forces are creating these opportunities?
The first force is credit disintermediation. Both midsize and large banks have faced more cost pressures and capital requirements, making it challenging for them to participate in some asset classes. As banks step back from certain lending activities, borrowers still need access to credit, opening the door to so-called private credit opportunities for nonbank lenders. We at AllianceBernstein have seen this trend accelerating for banks in the U.S. and Europe in the aftermath of the 2008–’09 financial crisis.
Here are two examples of opportunities created by credit disintermediation that in our view offer substantial illiquidity premiums:
• Middle-market loans, or private direct loans, have been in the spotlight because of the good downside protection they exhibit and because they are directly originated, which means lenders tend to have more control over the terms of the loans. This has resulted in the midmarket segment experiencing lower losses compared with large-cap liquid credit.
• Risk-sharing transactions are also emerging as a viable investment alternative, especially as the U.S. government redefines its role with government-sponsored enterprises in the mortgage investment market. Some of the tranches will be rated investment grade, which will make funding capital efficient.
Another source of illiquid investment opportunity is declining secondary market liquidity. Regulatory changes have affected banks’ fixed-income market-making abilities, reducing liquidity in secondary markets. Anxiety held over from the global financial crisis also has reduced liquidity for some fixed-income securities in secondary markets.
Here are a couple of examples where we think investors are getting rewarded for declining secondary-market liquidity:
• Closed-end funds have seen their discounts grow since the financial crisis. Today they offer investors the opportunity to buy into strategies at discounts as high as 10 percent of a fund’s underlying net asset value. Investors who traditionally go into open-end mutual funds might want to consider closed-end funds that pursue similar investment strategies while offering a discount.
• Municipal bonds, which have faced their share of challenges in recent years, tend to be more illiquid than other fixed-income securities because the secondary trading market is dominated by individual investors. Although credit spreads in taxable markets have declined from the worst of the financial crisis, in many cases they are still higher than they were before the crisis.
Understanding the liquidity premium presents a new dimension for fixed-income investing. In our view, taking the time to become more familiar with the factors driving these inefficiencies in private credit and capital markets should convince many investors to turn what may seem like illiquidity risk into opportunities.
Douglas Peebles is chief investment officer and head of fixed income at AllianceBernstein in New York.
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