Identifying Liquidity Risk in Fixed-Income Mutual Funds: A Quantitative Approach

Detecting Liquidity Risk: COVID-19 as Case in Point

The emergence of the COVID-19 pandemic, a “black swan” event, has brought bond fund illiquidity concerns to the forefront. While investors – especially those in categories such as multi-sector and enhanced core bond funds – are typically aware that actively managed products may invest in illiquid assets to seek higher returns (especially during periods of historically low yields), they may not always be aware of the specific risks that may be present in their investments, nor how these risks might be changing quickly over time.

The quantitative approach demonstrated in this paper provides a useful and pragmatic framework for investment practitioners to screen for potential concerns when selecting new products, as well as when conducting ongoing monitoring of their portfolio holdings.

When analyzing actively managed funds to get a clear picture of liquidity exposure, qualitative due diligence cannot usually detect rapid allocation changes, nor deconstruct a maze of complex holdings and derivatives to fully assess risk. It is here that analysts would normally turn to quantitative analysis, but many fixed-income specialists often consider such quant measures to be better suited to equities.

In this paper, we will demonstrate how quick, efficient and easily understood quantitative analysis can provide critical insights for investors and regulators, helping them to better assess ongoing risks in fixed-income products.