Ultimately, investors should be satisfied with the level of seniority associated with the instrument they purchased. An investment in a Tier 1 or hybrid bond does not provide the same level of protection that a similar investment in a senior debt instrument. Recently, certain bond holders invested in hybrid bonds were converted to preferred shareholders or in some cases, saw their coupons being deferred. This is a growing risk if the economy does not improve and issuers need to raise more capital.
The liquidity of fixed income instruments within the capital structure of an issuer also triggered additional problems for investors. Although the liquidity associated with selling a senior debt instrument has fared better from selling a Tier 1 bond from the same issuer, we cannot assume that every bond from a similar issuer will always trade with the same level of liquidity.
The bond markets
Another important differentiating factor between bonds and equities is the way these instruments are traded. Despite important dislocation in equity markets lately, investors were allowed to buy or sell most of the names in equity portfolios. Equities trade real-time, and investors know what they can get for their holdings. This is very different for fixed income instruments. Unlike stocks, bonds do not trade on an exchange. This means that investors first have to find the bond they want to buy, negotiate its price, and then execute the transaction to purchase the bond.
Since it is a dealers’ market, the pricing may vary depending on the size of the transaction and the demand for the bond. The pricing mechanism of the benchmark in Canada may not be fully representative of the actual trading environment around a specific transaction. In a situation where liquidity is scarce and few transactions are taking place, the value of a bond portfolio may not be representative of the value of this portfolio when it is time to liquidate it. The illiquidity of the bond market over the last couple of years was in part the result of investors who were not willing to mark down their assets at current levels and decided to wait for the storm to pass. Why take an important mark-to-market loss if an investor believes the issuers will pay them back at maturity?
Emerging from the crisis
Considering the fundamental differences between bonds and equities, investors should evaluate fixed income managers differently from equity managers. They should also revisit their asset mix and rebalancing policies, given that they were drafted in an environment where liquidity was taken for granted.
With the renewed focus on risk, understanding bonds and their realities will help investors to better navigate through additional challenges, such as rating agencies’ revised rating methodology combined with an increase in the probability of a country defaulting—as we experienced with Iceland and other Eastern European countries. Certainly, the domino effect following continued volatility in the credit markets will affect liquidity and the ability for pension plans to bounce back. The time has come for investors to look at their investment policies and ask themselves if liquidity can ever be taken for granted again.
Patrice Denis is vice-president, business development and client servicing with State Street Global Advisors Ltd. (Canada)
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