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Fixed Income Is Normally a Source of Liquidity. What to Do When It Isn’t?

03/19/2020

One of the major concerns for an institutional investor is maintaining sufficient liquidity in the portfolio during periods of high volatility and market stress. During the global financial crisis of 2008–2009, for example, many investors were challenged to raise cash for ongoing plan obligations (such as benefit payments and capital calls). At the same time, there was a desire to rebalance the portfolio out of asset classes that were overweight to their policy target (such as fixed income) and into asset classes that were underweight (such as equities). 


The problem many investors faced during this period was that the desired source of liquidity was the fixed income market, which at the time was strained from a liquidity perspective—much as it is now during the market downturn triggered by the coronavirus outbreak. Then as now, investors who chose to sell fixed income exposure were often forced to do so in illiquid markets in which assets were sold at steep discounts. During the global financial crisis, this had a negative effect on portfolio returns.


It raises a challenging question: How can investors remain in compliance with policy targets while maintaining sufficient liquidity for plan obligations?


For liquidity and rebalancing, turn to an overlay program 

Investors establish a strategic asset allocation with the goal of generating consistent long-term returns for plan beneficiaries. During market corrections or periods of high volatility, the plan can deviate significantly from the allocation, which can trigger mandatory rebalancing if stated in the plan’s investment policy statement. If a physical rebalance is executed during periods of market stress, managers in certain asset classes may be forced to sell at a discount due to decreased liquidity, negatively affecting performance.


In a period when liquidity is needed and portfolio rebalancing is necessary, an overlay program allows an investor to raise cash from the most liquid portion of their portfolio to use both for plan expenses and to rebalance the portfolio back to policy targets.


How does an overlay program help maintain liquidity? 

While counterintuitive at first, a unique solution used during the global financial crisis was to sell physical equities to raise liquidity both for ongoing cash needs and to fund a rebalancing overlay. Equities were a good target for liquidity because they remained relatively liquid during this period of market stress. While it may appear that this left investors with a more severe underweight to equities, the overlay program used this cash not only to replace the equity exposure that was sold but to also rebalance the overall portfolio exposures back to target. As a result, plans found themselves in a position to both create sufficient liquidity and maintain the desired asset allocation.


The goal of the rebalance in this example is simple: to reduce fixed income exposure and increase equity exposure. Assuming a portfolio has liquid equity exposure (passive exposure works well for this situation), an overlay program can achieve the goal in a capital-efficient manner while avoiding the discount associated with selling fixed income securities. Physical passive equity exposure can easily be substituted with equity futures without the need to fully fund the position. The illustration below gives you an idea of how this typically works.


portfolio asset mix with overlay table


Hypothetical. For illustrative purposes only.


In short, by selling passive physical equity exposure, adding synthetic equity exposure, and selling Treasury futures, institutional investors can rebalance in a capital-efficient manner and avoid forced selling of less liquid physical fixed income positions. 


The bottom line

During the global financial crisis, institutional investors that made smart use of an overlay program found themselves able to generate liquidity to rebalance their portfolio in a way they may not have been able to independently. By selling out of liquid asset classes, they sidestepped the negative effects of selling assets at a discount and instead remained on target. As the coronavirus outbreak roils markets today, it’s an approach whose time may have come once again.

Potential Parametric solution

Winners of the EQDerivatives 2020 Overlay Fund Manager of the Year award, we seek to achieve an investor’s policy objectives related to exposure management and cash securitization while helping minimize transaction costs. Our overlay solutions include a rebalancing of fund exposures in an efficient and cost-effective manner back to the desired allocation.



Justin Henne

Justin Henne, CFA, Managing Director, Customized Exposure Management

Justin leads the investment team responsible for the implementation and enhancement of Parametric’s Customized Exposure Management Strategy. Since joining Parametric in 2004 (originally as an employee of the Clifton Group, which was acquired by Parametric in 2012), Justin has gained extensive experience trading a wide variety of derivative instruments to meet each client’s unique exposure and risk management objectives. He earned a BA in financial management from the University of St. Thomas. A CFA charterholder, Justin is a member of the CFA Society of Minnesota.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.


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