Does the recent improvement in risk sentiment predicated on good vibes around the “Phase One” Sino-US trade deal and ostensible “progress” on Brexit make the case for going out on a limb and leaning into the illiquidity premium in corporate credit?
In a word, “no”.
Or at least not according to Goldman, whose credit team reminds you that “the value proposition of owning illiquid risk is weak”. We touched on this a while back, and the bank delivered a short update on the subject Thursday.
“While sentiment vis-à-vis trade tensions has somewhat improved, the IG illiquidity premium, which we proxy by the excess spread embedded in illiquid bonds relative to liquid bonds, has further widened”, the bank notes.
For Goldman, it’s likely that between the still tenuous outlook for global growth (and really, one could simply say that the outlook is deteriorating by the week, a few “green shoots” here and there notwithstanding), sky-high policy uncertainty and relatively expensive valuations, there’s plenty of room for illiquid credit to underperform.
The outlook for illiquid credit risk is made worse by what Goldman describes as “the more fragile post-crisis market microstructure”. Indeed, if there’s any time when one should “stay liquid” (so to speak) it’s headed into Q4.
“The past three years have seen trading volumes and liquidity measures exhibit strong seasonality, deteriorating in 4Q before subsequently improving in 1Q of the following year”, Goldman warns, adding that 2019 likely won’t be an exception.
If you’re wondering what to blame for that, one place to start is G-SIB buffer thresholds.
“GSIB constraints encourage dealers to shrink the overall size of their market making activities”, BofA’s Mark Cabana reminds you, on the way to noting the following in a Friday note:
As of Q2 ‘19, four of the eight GSIBs were in a higher GSIB surcharge bucket versus 2018 year end (Table 4). The fact that there are four US GSIBs running high in their surcharge bucket as of Q2 ’19 stands in stark contrast to the fact that there was only 1 US GSIB that was running high in its target range as of Q2 ’18. This suggests there will likely be greater year-end funding strains in ’19 vs ’18 regardless of how the Fed manages their reserves.
The point: The Fed’s efforts to ameliorate the situation aside, there are significant questions about what Q4 will bring in terms of structural stress and how that will impact liquidity provision and thereby markets.
The only thing anyone knows for sure is that there will be a negative seasonal effect.