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Put Your Bond Manager To The Liquidity Test

Put Your Bond Manager To The Liquidity Test by Douglas J. Peebles and Ashish Shah, AllianceBernstein

Bond market liquidity is drying up—something every investor and financial advisor should take seriously. But liquidity risk can also provide an additional source of returns. The trick is knowing how to manage it.

This is why picking the right manager is critical. Before entrusting money to anyone, investors or their advisors should make sure prospective managers understand why liquidity is evaporating and have an investment process that can effectively manage this growing risk.

In our view, settling for anything less will make it harder to protect your portfolio from the damage less liquid markets can cause—and to seize the opportunities they offer.

Here are some questions that we feel investors should be asking.

1) To what do you attribute the decline in liquidity?

For most people, an asset is liquid if it can be bought or sold quickly without significantly affecting its price—something that’s become more difficult lately.

Many market participants blame post–financial crisis banking regulations. Designed to make banks safer, the new rules have also made them less willing to take risks. Consequently, most banks are no longer big buyers and sellers of corporate bonds. In the past, banks’ involvement—particularly in high yield—helped keep price fluctuations in check and meant investors could usually count on them as buyers when others wanted to sell.

But because they affect the supply of liquidity, regulations are only part of the story. Several other trends have drastically increased the potential demand for liquidity. These include investor...