Many market watchers cite liquidity – or the lack of it – as a major contributing factor when an investment vehicle or an entire sector suffers a significant loss during a period of market stress. This view is understandable given the empirical relationship between market liquidity and market volatility and the elusive nature of liquidity conditions during recent stress events including the 2008 financial crisis.

PIMCO’s view is that a robust portfolio liquidity risk management program can both help ensure that portfolios are well-positioned to withstand stress scenarios and allow portfolios to potentially take advantage of opportunities provided by market dislocations. Liquidity risk management is a pillar of the PIMCO portfolio and risk management process. It is a key consideration in portfolio construction and is complemented by diligent monitoring every business day within a framework that provides flexibility to incorporate impacts from evolving market conditions.

We describe market liquidity and portfolio liquidity as two interconnected but distinct variables:

• Market liquidity refers to the ability to purchase or sell securities in the market.
• Portfolio liquidity is defined as the ability to adjust positioning in a portfolio in response to flows or changing market conditions, or to satisfy investor redemption requests without structurally changing portfolio exposures.

Three reasons to manage liquidity

One component of the PIMCO approach to managing portfolio liquidity is setting risk-sensitive portfolio-level targets for highly liquid assets.¹ There are three primary motivations for maintaining portfolio liquidity in highly liquid assets: 1) Commingled or mutual funds must be prepared to meet potential client redemption requests on demand. 2) Portfolios must be prepared to meet potential collateral or margin call needs for derivative or forward settling positions. 3) Portfolios should be in a position to take advantage of potential market dislocations. They do this by having sufficient “dry powder” to buy attractive assets in market stress scenarios, with the intent to contribute positively to overall portfolio returns.

Selecting the liquidity target

PIMCO utilizes stress testing and vigorous historical data analysis to determine targets for highly liquid assets at a portfolio level. Stress scenarios are calibrated to periods of high volatility or market stress and parameterized to realized historical stress periods while also incorporating hypothetical shifts in asset correlations.

We test all portfolios every business day to ensure that a highly liquid asset buffer is maintained that meets or exceeds the established target. The assessment of a portfolio’s highly liquid asset position includes both an analysis of expected future cash flows and identification of portfolio holdings that may reasonably be sold or financed via the repo market. We also consider the base currency of the portfolio and expected timing for exchanging settled foreign currency back to the base currency. The securities identified as highly liquid are reviewed regularly by the portfolio risk team and the Investment Committee with input from specialist desks.

Managing liquidity risk amid shifting markets

Being sufficiently liquid today does not guarantee that a portfolio will be liquid next week. While the maintenance of a prudently calibrated liquid asset buffer directly addresses potential needs for portfolio liquidity, it is not sufficient when liquidity conditions are subject to change.

PIMCO’s rigorous portfolio management process employs internally developed analytics to manage the risks of shifting markets and liquidity challenges. Of critical importance, the portfolio risk team monitors portfolio concentrations in single issuers, industries and sectors relative to internally defined limits that are informed by our credit analyst team’s assessment of issuer credit risk. These bottom-up concentration limits supplement the portfolio risk team’s focus on portfolio risk factor exposures relative to Investment Committee targets, attribution of realized performance to risk drivers, and forward-looking stress tests.

We utilize portfolio-level stress tests to assess the portfolio performance impact from potential tail events or an adverse market move on the portfolio’s highest-conviction positions. We compare the results of the stress test to the portfolio’s risk tolerance, in an effort to identify sources of dispersion in portfolios with similar mandates.

Derivatives: one tool for managing liquidity

Given the trade-off between maintaining a liquid asset buffer and fully investing the portfolio in assets geared toward its main objectives, we may employ derivatives to manage risk and maximize risk-adjusted return potential.

Derivatives may be used as a liquid substitute to achieve the same exposure as a physical security or to replicate a benchmark beta. For instance, if we are trying to get exposure to a 10-year U.S. Treasury bond, we could either buy the physical bond or buy a 10-year Treasury bond future, depending on pricing and liquidity. In certain markets, such as corporate credit, a derivative referencing a diversified credit index may provide better liquidity relative to replicating the exposure in the underlying single-name credit default swap or bond market as measured by bid-ask cost and market depth. Further, in stressed market conditions, the liquidity in the derivative may be positively convex in that it improves as a result of increased demand for liquid hedges.

Derivatives, and the investment strategies that use them, can potentially magnify investment risks if not appropriately risk-managed. Our use of derivatives – and indeed our entire investment process – aims to maximize the opportunities found across the investment landscape, using these instruments within the constraints of prudent portfolio and counterparty risk management.

PIMCO has an extensive experience and rigorous processes in place to manage derivative investments and to effectively manage counterparty risk. These include evaluation and oversight of counterparty and clearing broker creditworthiness, trading under industry standard contracts and collateralization of derivative exposures every business day with counterparties and central counterparty clearing houses.

Global outlook for liquidity management

With the economic cycle in the late stages of a long expansion, we have started to see pockets of disturbance in the liquidity conditions in certain market segments. One notable example was the VIX (CBOE Volatility Index) spike in February 2018, which some market participants ascribed to technical trading dynamics in the equity market. Recent multiple-sigma stress events in Italian government bonds and select emerging markets have been followed by a reduction in market liquidity as evidenced by reduced market depth and wider bid-ask spreads.

With central banks in the U.S. and Europe withdrawing liquidity and regulation raising the costs for intermediating trades via increased capital requirements, the risk that future shocks result in market liquidity events has increased, in our view.

Key takeaways for investors

A robust liquidity risk management program is a critical component of portfolio construction. Stress testing techniques that are calibrated to higher volatility and stress conditions may help strengthen a portfolio to better withstand potential future market shocks. In addition, we are focused on portfolio positioning in concentrated sectors, high beta holdings, and assets that have a higher reliance on funding given where we are in the cycle and our assessment of risk factors that could affect market liquidity.

As active managers, we find the ability to respond to market stress and exploit liquidity premiums can be a fundamental driver of positive returns, and the ongoing management of portfolio liquidity risk is key to being able to take advantage of those opportunities.