Over-Rated: Do Fund Asset Classifications Tell The Whole Liquidity Story?
By Hamlin Lovell, CFA Suspensions of dealing by the credit mutual funds Third Avenue and Stone Lion have prompted various knee-jerk requests for a simple rule of thumb to help avoid recurrence: Beware Level 3 assets. It is reported that Third Avenue owned 18% in Level 3 assets. Many credit funds have zero or less than 1% of their assets in this category. Behavioral finance teaches us that we are susceptible to messages that simplify the complex. Unfortunately, financial market liquidity may not be amenable to such simple rules. Level 3 assets are assets for which a fair value can’t be determined by observable measures such as models or market prices. Though they are commonly dubbed mark-to-model, any unobservable input applied to modify a market price can also lead assets to be classified as Level 3 despite their valuation not being entirely model driven. Furthermore, relying on the Level 1/2/3 breakdown as a proxy for liquidity can result in both false positives and false negatives. Let’s start with the false negatives. Absent or insufficient market prices or dealer quotes can be reasons for Level 3 classifications, but they are not the only reasons. For instance, derivatives with non-standard maturities may be valued by interpolating between broker quotes on those derivatives with standard maturities. So a six-week currency option might be valued roughly halfway between a one-month and a two-month quote, but if the fund in question offers quarterly dealing, there need not be grounds for concern about asset/liability mismatches. But Level 3 is a broad range. At the other end of the spectrum, Level 3 could include private equity that might never be monetized, leading to an immortal “zombie” fund. Many assets might fall between these negative extremes; structured credit, for example, can be self-liquidating if cash flows from underlying assets accrue to various tranches according to the predetermined schedule. Some short-dated structured credit assets could generate cash flows faster than, say, zero coupon or payment-in-kind (PIK) bonds, where there may be indicative broker quotes – but you’d only find out if the borrower could repay (or refinance) at the maturity date! So using Level 3 categorizations to avoid illiquids is a crude tool. Of course, for those investors not worried about missing some adequately liquid assets falling under the Level 3 umbrella, a “Level 3 is bad” rule should still avoid many of the least liquid and completely illiquid assets. Less discussed and of greater concern are the false positives that can arise from assuming Level 1 and Level 2 must be liquid. That assets have an exchange price or some form of counterparty quote does not mean they can be traded in unlimited amounts, as the price or quote may only be good up to certain volume levels. Indeed, Third Avenue claimed it cannot liquidate “at rational prices,” which may imply they could sell at discounted prices. Any asset’s liquidity needs to be seen in the context of the fund’s position size, and I have seen funds take months or years to exit some Level 1 or Level 2 securities when they are holding a substantial multiple of volumes. The bottom line is that valuation methods should not be used to draw inferences about liquidity. Credit Ratings Third Avenue owned significant amounts of assets with a CCC credit rating, which may be deemed extremely speculative. The impulsive response here is to suggest that funds with higher credit ratings are more liquid, or less risky, or both, than those with lower (or no) credit ratings. Let us remind ourselves that some asset-backed security vehicles stamped AAA and backed by subprime mortgages ended up worthless and illiquid during and after the 2008 crisis, to the chagrin of institutional investors ranging from Norwegian pension funds to German municipal banks. Some money market funds that were perceived as super-safe cash substitutes also had to suspend dealing in 2008, and they were, broadly speaking, required by Rule 2a-7 to hold assets bearing the highest two short-term credit ratings. Since September 2015, money market funds are no longer bound by this constraint , as Dodd-Frank requires them to ensure assets meet a range of appropriate criteria. “Unrated” Assets When an asset is unrated, it generally means that the issuer has declined to pay for a credit rating rather than that the ratings agency has declined to provide one. The amount of C-rated issuance seen in the United States and Europe over the past two years shows that agencies are perfectly willing to provide some of the lowest credit ratings to companies that may be stressed or distressed. Convertible debt is often not rated, but this does not necessarily mean it is less liquid. I recall convertible bond funds largely comprising unrated names in 2008 paying out plenty of redemptions on time. In any case, credit ratings are not necessarily a reliable proxy for liquidity. Some credit assets reportedly see higher volumes after they get downgraded or default, partly because some holders become forced sellers and specialist distressed investors then become interested in the higher potential returns on offer. So, neither valuation hierarchies nor credit ratings can necessarily guarantee fund liquidity. Nor can regulation – both US mutual funds and US money market funds are now allowed to suspend dealing, and the SEC has approved Third Avenue’s suspension. Investors and advisers need to broaden and deepen their levels of analysis to get a better handle on liquidity risks. Quantifying fund liquidity is not only nuanced but also fluid, particularly as there can be seasonal variations, with calendar year-end reportedly a less liquid time. Investors and asset management companies may be drawn to the apparent certainty of putting funds into a small number of boxes, buckets, or categories, but this may prove to be a false comfort. Exact estimates of fund liquidity could prove to be spuriously precise, so the concept needs to be presented in broad brush terms that allow plenty of margin for error. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.