Crisis? What crisis?

Eaton Vance’s popular trading boss makes his case on why he believes concerns about illiquidity are overblown.

Since the end of the 2008 financial crisis, fixed income markets have had higher liquidity costs and greater price volatility.

This is largely a direct result of post-crisis financial reform, as actions taken by central bankers and regulators effectively transferred risk from the banking system to investors in the capital markets.

The Eaton Vance global income team believes that liquidity risk, like interest-rate risk and credit risk, can be best managed by focusing on trading in those specific risk factors, rather than just individual securities that package multiple factors together.

Of course, the first step to managing liquidity risk is understanding what liquidity really means. From our perspective, as long as there is a buyer and a seller for a given security, it is liquid.

A separate, important question is the price of that liquidity – most commonly expressed as the spread between the bid and the offer.

Spreads can widen in sectors or securities due to any number of technical or fundamental factors, and such widening increases liquidity’s cost.

But that should not be confused with illiquidity, which has been a very rare, transient occurrence in major US capital markets.

In the absence of a true liquidity crisis, most concerns about “illiquidity” are unfounded, and describing securities as “illiquid” can be potentially misleading. Here are three common misconceptions:

The price of liquidity is fixed – Liquidity is a good and, like all other goods, the price varies under different scenarios and over time. Some investors, however, apparently believe that it is unvarying. Thus, when bid/offer spreads increase for a security, it is mistakenly deemed “illiquid.”

Liquidity costs too much – Some investors believe a security is “illiquid” when the bid/offer spread exceeds their willingness to pay the cost.

While undoubtedly painful and unfortunate for an individual investor, the price of liquidity is market-driven. Liquidity is available for those prepared to accept the premium required to buy or sell.

Liquidity varies by bond position size – Some investors define liquidity based on how long it would take to sell their entire position in a particular security. The per-unit cost of liquidity for larger positions may be greater than for smaller ones, but it is not the liquidity that changes with position size, just its price.

Bottom line

Fluctuating liquidity costs and bond prices are part of normally functioning markets. Investors who understand these dynamics may be well-positioned to benefit over the medium-to-longer term.