Fixed Income Liquidity Premium Capture Strategy
Fixed Income Liquidity Premium Capture is a strategy that focuses on earning extra returns by trading fixed-income securities that offer a higher yield due to their lower liquidity.
This premium compensates traders for the additional risk and potential difficulty in trading these securities.
Key Takeaways – Fixed Income Liquidity Premium Capture Strategy
- Yield Spread Opportunities
- Capture higher yields by trading less liquid fixed income securities, such as certain corporate bonds, that offer a liquidity premium.
- Selection and Monitoring
- Less liquid assets carry higher market and credit risks.
- Active Management
- Adjust the portfolio to exploit changes in liquidity conditions.
- Maximize returns when the liquidity premium narrows.
Liquidity Premium
The liquidity premium is the additional yield that traders/investors demand for holding a less liquid asset.
In fixed-income markets, less liquid securities, such as certain corporate bonds or structured products, often offer higher yields compared to more liquid securities like government bonds.
Key Concepts
Liquidity
Liquidity refers to the ease with which an asset can be bought or sold in the market without affecting its price.
Highly liquid assets can be traded quickly and with minimal price impact.
Illiquid assets may require more time and potentially significant price concessions to trade.
Yield Spread
The yield spread is the difference in yields between two fixed-income securities, typically between a less liquid and a more liquid asset.
This spread is a key measure of the liquidity premium.
Factors Influencing Liquidity Premium
Market Environment
The liquidity premium is determined by the market.
During periods of market stress, the premium tends to widen as traders/investors demand higher compensation for the risk of holding less liquid securities.
Issuer Characteristics
The issuer’s creditworthiness and market presence can influence the liquidity of its securities.
Bonds from well-known, financially stable issuers are generally more liquid than those from lesser-known or riskier issuers.
Security Features
The features of the security itself – e.g., its maturity, coupon structure, and embedded options – can also affect its liquidity.
For example, longer-term bonds and those with complex structures may be less liquid.
What’s a Common Liquidity Premium?
Liquidity premiums vary but generally, government bonds have a lower liquidity premium compared to corporate bonds.
For government bonds, the liquidity premium is often around 0.10% to 0.20%.
In contrast, corporate bonds typically carry a higher liquidity premium, ranging from 0.50% to 1.00%, depending on the credit quality and market environment.
These estimates can fluctuate based on factors like economic stability and flows and positioning.
Strategies for Capturing Liquidity Premium
Security Selection
Traders/investors can capture the liquidity premium by carefully selecting fixed-income securities that offer higher yields due to their lower liquidity.
Related: Fixed Income Analysis
Portfolio Diversification
Diversifying the portfolio – across various sectors, issuers, and maturities – can help manage the risks pertaining to less liquid securities.
A well-diversified portfolio can balance the higher yields from illiquid assets with the stability of more liquid ones.
Active Management
Active management involves adjusting the portfolio to take advantage of changing liquidity conditions.
This can include buying undervalued, less liquid securities and selling them when their liquidity improves and the yield spread narrows.
On-The-Run vs. Off-The-Run Bond Strategies
On-the-run securities are the most recently issued and actively traded bonds, while off-the-run securities are older issues that are less liquid and traded less frequently.
The fixed income liquidity premium capture strategy involves trading in off-the-run securities, which typically offer higher yields compared to on-the-run securities due to their lower liquidity.
Targeting these off-the-run securities can enable traders to take advantage of the liquidity premium and gain additional returns for accepting the higher liquidity risk.
Risks and Challenges
Market Risk
The value of less liquid securities can be more volatile, especially during market downturns.
Traders/investors also need to brace for potential difficulty in selling these assets quickly, if necessary.
Bid-ask spreads can be very wide in these securities.
Some credit instruments literally don’t trade all day.
Credit Risk
Trading less liquid securities often involves taking on higher credit risk.
Liquidity Risk
The primary risk of this strategy is liquidity risk – the risk that the trader/investor may not be able to sell the security quickly or at a fair price.
This can be particularly problematic during times of market stress.
Let’s look at some trades involving fixed income liquidity premium capture:
Trade 1: Investing in Corporate Bonds with Higher Liquidity Premium
Step-by-Step Process
Research and Identify Bonds
Identify a less liquid corporate bond with a higher yield due to its lower liquidity.
For example, a BBB-rated corporate bond from Company X with a yield of 5% compared to a more liquid A-rated bond from Company Y with a yield of 3%.
Determine Investment Amount
Decide on the amount, for instance, $50,000.
Execute the Trade
Place an order for $50,000 worth of Company X’s BBB-rated bonds.
Be sure to specify the desired price or yield.
Monitor
Monitor the credit rating and conditions of Company X.
Be prepared to hold the bond until maturity if liquidity conditions don’t improve.
Example Calculation
- Purchased $50,000 of Company X’s BBB-rated bonds at a 5% yield
- Annual interest income: $50,000 * 5% = $2,500
Trade 2: Buying Municipal Bonds with Lower Liquidity
Step-by-Step Process
Identify Municipal Bonds
Find a municipal bond from a smaller municipality with lower liquidity but offering a higher yield.
Example: A municipal bond from City Z with a yield of 4.5%, compared to a more liquid municipal bond from City A with a yield of 3%.
Decide on Investment Amount
Choose an amount to trade, such as $20,000.
Place the Order
Use your brokerage account to place an order for $20,000 of City Z’s municipal bonds.
Specify the price or yield target.
Hold and Review
Regularly review the financial health of City Z and market conditions.
Be prepared for longer holding periods due to lower liquidity.
Example Calculation
- Invested $20,000 in City Z’s municipal bonds at a 4.5% yield
- Annual interest income: $20,000 * 4.5% = $900
Trade 3: Purchasing High-Yield Emerging Market Bonds
Process
Research Emerging Market Bonds
Identify an emerging market sovereign bond with higher yields due to liquidity risks.
Example: A sovereign bond from Country Q offering a yield of 6.5%.
Decide on the Amount to Invest
Determine the amount, such as $100,000.
Place the Trade
Use your broker to purchase $100,000 of Country Q’s sovereign bonds.
Ongoing Monitoring
Keep an eye on the economic and political situation in Country Q.
Be ready to hold the bond through periods of market volatility.
Example Calculation
- $100,000 in Country Q’s sovereign bonds at a 6.5% yield.
- Annual interest income: $100,000 * 6.5% = $6,500.
Trade 4: Investing in High-Yield Corporate Bond ETFs
Process
Select an ETF
Choose a high-yield corporate bond ETF that includes less liquid securities.
Example: An ETF with an average yield of 5.5%.
Determine Investment Amount
Decide to invest $30,000 in the ETF.
Execute the Purchase
Place an order through your brokerage account for $30,000 worth of the high-yield corporate bond ETF.
Consider any brokerage fees or transaction costs.
Monitor ETF Performance
Regularly review the ETF’s performance and underlying holdings.
Assess liquidity conditions and market trends affecting the ETF.
Example Calculation
- Purchased $30,000 of high-yield corporate bond ETF at an average yield of 5.5%.
- Annual income from the ETF: $30,000 * 5.5% = $1,6500.
Note
Some traders will short a closely related, lower-yield liquid bond to hedge out market risk and capture the yield differential.
This isn’t pure arbitrage even if the hedge is exact or nearly exact, given the liquidity differential.