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Willis Towers Watson paper warns institutional investors on changes in credit market liquidity

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A new research paper from Willis Towers Watson – Capital market liquidity – stresses that the nature of credit market liquidity has fundamentally changed following a significant fall in the depth and breadth of liquidity.

Chris Redmond, global head of credit research at Willis Towers Watson, says: “We worry that the supply of liquidity is no longer capable of satiating demand. This will become obvious and painful during periods of market stress where investors seek to re-position or realise cash from commingled funds offering overly generous redemption terms.”
 
The company points to the Taper Tantrum in 2013 and the US Treasury Flash Crash in 2014 as examples of challenging market behaviour and volatility as valuable windows into possible future scenarios. It says that while the markets in question quickly calmed after the period of elevated volatility, this should be of no comfort to investors.
 
Redmond says: “Both events occurred during an overall environment of generally benign economic conditions and a generally positive risk appetite amongst investors. We worry about how credit markets might behave during a period of genuine macroeconomic uncertainty where investors’ asset allocations are materially changing and they are all trying to sell credit assets.”
 
Willis Towers Watson suggests investors take certain actions to insulate their credit portfolios against future periods of extreme credit market volatility and illiquidity, including reviewing fund and liquidity terms and assess the ongoing efficacy of different investment styles.
 
In another research paper, entitled Understanding and measuring the illiquidity risk premium, the company observes that investors generally do not have a good understanding of what they are 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 Illiquidity Risk Premium 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.
 
Martin Jecks, senior investment consultant at Willis Towers Watson, says: “This approach is a useful input in portfolio construction when determining how to spend a given illiquidity budget based on what an asset class is actually offering in compensation for its illiquidity.”
 
The company warns that its Illiquidity Risk Premium 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 premia – including IRPs – higher.
 
Jecks says: “While we believe there is a higher chance than normal of a downside event occurring and maintain a cautious outlook on risky assets, for many investors suited to taking illiquidity risk, certain assets still provide attractive risk premia on a highly selective basis. Moreover, if a negative event does occur and illiquidity risk premia do increase, these investors should stand ready to capture these attractive returns. Often this requires investment at a difficult time, but having a solid process and plan to estimate the illiquidity risk premia eases this decision.”

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