Eyes on risk management
Mercer - Investments
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By Ursula Niederberger, CEFA, CAIA Senior Strategic Investment Research Specialist and Head of Operations
The multitude of regime shifts currently underway has led to a renewed focus on risk management. Years of cheap money have come to an end as financial conditions have tightened. Markets will shift and the risks rewarded in the recent past will likely not persist. New policy rules and a different economic cycle suggest the need to gain a fresh perspective on risk factors ahead.
Market air pockets
The withdrawal of central bank liquidity can create air pockets in markets, especially where leverage is involved. We witnessed one such event in the rapid spike in gilt yields catalyzed by the UK’s “mini-budget” on September 23. This caused a sharp decline in the notional value of associated interest rate derivatives, requiring massive collateral calls on UK DB pension funds. The scale of the collateral requirements triggered UK pension funds to rapidly liquidate assets as they scrambled to find the necessary cash to support these collateral calls. While the Bank of England temporarily stepped in to calm the market, the limits of fiscal policy without the support of monetary policy were made clear.
Vehicle liquidity mismatch
Mounting withdrawals in large real estate funds of prominent asset managers12 exposed the vulnerability of funds with a mismatch in vehicle and underlying asset liquidity. Unlike publicly traded REITs and BDCs13 , these private open-ended, semiliquid funds lack permanent capital, are leveraged, and are invested in private markets where “marked” valuations lag valuations in the publicly traded markets. Rising redemption requests tend to bring about more redemption requests as investors scramble to get in early to the redemption queue.
Shifting marginal buyers
The pull-back in central bank liquidity has altered the marginal buyer. An example of this is US agency mortgage-backed securities (MBS). Trading volumes declined in 2022 and yield spreads over US Treasuries rose. With the marginal buyer shifting from central banks to levered participants, like mortgage REITs, agency MBS became more volatile than in the past few decades.14 Beyond areas of direct intervention, the broader market has pushed the proverbial Fed put further out of the money due to the ongoing battle with inflation.
Tenuous exit plans in private markets
Exit activity has fallen below its short- and long-term trends. Liquidity from public listings has completely dried up, while sales to financial sponsors have continued to take up a greater share of overall exits. The illiquidity issues and lack of mark-tomarket pricing likely will contribute to a difficult fundraising environment in the coming quarters.15
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Beyond these more structural shifts in conditions resulting from the regime shift we are experiencing, there are a number of other examples of liquidity stress in markets today: the leveraged loan market, which has been the primary source of buyout debt, has softened rapidly, and is at its lowest level since mid-2020; liquidity from public listings has completely dried up; a heightened awareness of counterparty risk has seen CDS16 prices increasing; and there have been multi-billion dollar failures in the crypto industry.17
The effects of the end of free money and the withdrawal of liquidity are clearly being felt. Liquidity management has always been a key tenet of any governance process, but the radically different conditions over the last year have clearly tested investors. The regime shift is such that investors should expect and prepare for more shocks along the way.
Governance processes adopted by an organization need to be built around the circumstances of that organization and the way to prepare for potential risks depends on the investor’s individual objectives and investment horizon. The specific tools available to address those stresses also vary as markets evolve. The following framework can help to plan ahead.
13 Business development company (BDC) is an investment firm that typically invests in small and medium-sized companies to help them grow.
16 Credit default swaps
17 Full time for FTX - A perspective on the ongoing “Crypto Winter” – Mercer November 2022 https://insightcommunity.mercer.com/research/637eafed48a5d30021db16cb/Mercer_Full_time_for_FTX_A_perspective_on_the_o ngoing_Crypto_Winter
Inside Sales Representative (Lighting) at DSI Southwest (DSI Lighting Group)
2 年Insightful and timely article! Great job, Mercer - Investments!