Willis Towers Watson introduced its Illiquidity Risk Premium (IRP) Index.
In a research paper, “Understanding and Measuring the Illiquidity Risk Premium,”
the company observes that investors generally do not have a good
understanding of what they’re being paid for having their capital locked
up. By referencing the principle “what gets measured gets managed,” the
company explores what investors should demand for accepting illiquidity
risk and how this can be measured by using a new IRP index.
According
to Willis Towers Watson, the index enables comparison of IRPs across
assets on a consistent basis, so as to make relative-value statements
about the attractiveness of taking illiquidity risk across those assets.
Thierry Adant, a consultant for credit research at Willis Towers
Watson in New York City, tells PLANADVISER, “We think liquidity listing
is underutilized. Having a good understanding of whether [defined
benefit plan sponsors] are getting paid enough is better than blind
allocations. The index helps plan sponsors determine where and when it
is good to take liquidity risk.”
According to Adant, the IRP
Index is a proprietary offering Willis Towers Watson has been using for a
number of years, but is now introducing it to investors because of a change in the market liquidity regime, not just for bonds but other assets. “If [liquidity] is managed correctly, it can make a big difference over time,” he says.
The
company warns that its IRP index currently indicates that IRPs are at
the low end of fair value and are likely to remain so for some time
unless there is a significant downside event, which would push all risk
premium—including IRPs—higher.
Defined benefit (DB) plan sponsors are credit investors;
they have investments in Treasury bonds and investment grade corporate bonds,
and they may also invest in direct lending. Liquidity can be a concern when
there is an asset/liability mismatch in commingled vehicles, and there is a risk
that funds may sell illiquid assets to meet redemption requests.
Thierry Adant, a consultant for credit research at Willis
Towers Watson in New York City, tells PLANADVISER there is a new market
liquidity regime, in part due to banks no longer being in the business of
holding an “inventory” of credit bonds to match redemption demand. DB plan
sponsors should act to protect themselves in the new regime, and in some cases,
they can even capitalize from it.
A Willis Towers Watson paper, “Credit Market Liquidity,” says
in the new banking regulatory regime, banks have significantly decreased their
stock of credit bonds since regulators have made it much more expensive for
them to hold such an inventory. The result was that in 2015, inventory in
corporate bonds averaged less than one day’s trading volume in corporate bonds,
with inventory roughly 25% versus peak levels. “In our view, credit market
liquidity has deteriorated as a consequence of the new regulatory regime,” the
paper says.
The firm is concerned that the supply of liquidity is no
longer capable of satiating demand, which will become obvious during periods of
market stress, when investors often seek to reposition.
According to Adant, this has been seen already a couple of
times in the market—the two worst episodes were the 2013 “Taper Tantrum” and
the October 2014 U.S. Treasury “flash crash”—but Adant thinks it is more
prevalent. “There are broader implications of asset/liability mismatch,” he
says. “If [a DB plan sponsor’s investment] strategy requires a high level of
turnover, there will be less returns because liquidity is more expensive.”
He notes that liquidity risks are on the agenda of
regulators. For example, in the mutual fund space, the Securities and Exchange
Commission (SEC) has proposed a set of reforms about
open-end funds’ liquidity management programs.
NEXT: What should plan sponsors do?
Adant says DB plan sponsors should assess whether they are
in the right vehicle structures or funds offering the right liquidity terms.
Certain strategies may not be workable. “The best example is credit long/short
or hedge fund type strategies,” he says, adding that the number of bonds that
trade actively and can execute an effective strategy has diminished, so plan
sponsors may not have many options in facilitating trades.
The Willis Towers Watson paper also suggests plan sponsors
review the liquidity and fund terms of all the commingled products in which
they invest. “Indeed, we strongly believe that an evolution in commingled fund
liquidity terms would serve to reduce the risks associated with the new credit
market liquidity regime,” it says. Plan sponsors should negotiate for better
terms, or shift to products that are better structured where possible.
Other suggestions include monitoring cash in commingled
investment funds. Commingled funds will run with higher cash balances to
reflect the new liquidity regime, which will create a drag on performance. Plan
sponsors should seek to renegotiate investment management fees down
accordingly.
The paper suggests plan sponsors budget for higher
volatility and higher trading costs in their portfolios. “Almost all investment
managers profess a willingness to act as a ‘supplier of liquidity’ to replace
the investment banks. In reality, this is incredibly challenging given the difficulty
of forecasting these episodic periods of high volatility and constraints around
expanding balance sheets in order to exploit market weakness,” it says.
Despite the risks, Adant says there is still an excess
return to be had. There are a number of opportunities plan sponsors should
consider as part of tactical as well as strategic asset allocation. For
example, according to the Willis Towers Watson paper, it is expected that the
illiquidity risk premium will be, on average, higher to compensate for
investors under the new regime. “This presents an opportunity for institutional
investors with a long investment horizon to be able to ‘lock up’ their capital
and generate higher returns,” the paper says.