lashantz - fixed income leaders combined presentation v.20150604

©2015 Brown Brothers Harriman & Co. Confidential & Proprietary. Not to be reproduced without the explicit consent of BBH & Co.

"BBH" and "BBH & Co." are registered service marks of Brown Brothers Harriman & Co.

June 4, 2015

Panel Discussion: “Commingled Fund Liquidity – Overcoming the Drought”



Presenters

2

Leighton Shantz, CFADirector of Fixed IncomeEmployees Retirement System of [email protected]

Andrew P. HoferManaging DirectorHead of Taxable Fixed IncomeBrown Brothers Harriman & [email protected]

Overcoming the Drought

This information has been prepared for sophisticated investors and their advisors. It is to be used in connection with a one-on-one presentation only.

mailto:[email protected]



Credit has enjoyed large fund inflows.

4

Source: Federal Reserve, Haver Analytics, ICI, NY Fed, Bloomberg

Liquidity likely to prove a problem on the way out



Turnover is down.

5

Sources:BIS, “Shifting Tides: Market Liquidity and Market-Making in Fixed Income Instruments”, BIS Quarterly Review, March 2015



The divide between large and small corporate issues is diverging as well.

6

Source: JP Morgan “US Corporate Bond Market Liquidity, an Update”, April 7, 2015. TRACE


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Is the problem worse in higher quality….?IG has exhibited less volatility, but higher frictional costs than High Yield

Source: Deutsche Bank, “Signs of Liquidity Vacuum in Unexpected Places”, May 20, 2015

Proportionate Volatility…… Disproportionate Bid-Ask


“BBH” and “BBH & Co.” are registered service marks of Brown Brothers Harriman & Co.

Source: Credit Suisse, US Interest Rate Strategy Focus, May 13, 2015

..are even Treasuries less liquid?





Potential Causes:

9

• Macro-prudential Regulation: Dodd-Frank, risk-based capital, ‘systemic importance”

• QE by governments

• Growth of funds and total return investors

• Herding of fixed income investors

• Greater interest rate risk in credit instruments

• TRACE transparency: help or hindrance?

• Concentration of dealers and buy side relative to the past

• New fund rules for valuation and liquidity

• Disappearance of levered vehicles such as SIVs and fixed income hedge funds



Multiple regulations discourage credit risk on dealer balance sheetsNew Constraints that are likely to be pro-cyclical

• Liquidity Coverage Ratio: Only certain “liquid” IG names qualify at 50% haircut (“level 2B”)

- “2B or not 2B”; Likely to make dealers/banks act like Funds

• Volcker Rule: reporting 7/2015; market-making exemption requires making two-way markets, not opportunistic buying.

• Basel 3:

Source: Federal Reserve, “Assessing Fixed Income Market Liquidity, Presentation to TBAC, July 2013

10

Sources: Bloomberg, Barclays, Federal Reserve

Dodd-Frank Effective

Dodd-Frank Signed

Lehman Files



We have some questions for regulators:

12

• In the desire to remove systemic risks, have we pushed market making out of regulatory purview and deprived the Fed of a policy lever?

- The remaining dealer banks are fewer and larger, and new capital regulations are, arguably, pro-cyclical.

— In the 1987 market crash, the Fed made sure specialists had credit lines

— In the crisis, the Fed opened the discount window to investment banks

— What counter-cyclical policy lever do you have now?

• If gates are now required features of Money Funds, why are regular (40 Act) fixed income funds effectively unable to gate?

- Compare unfavorably to UCITS rules



Monetary policy has affected the market

Sources: Federal Reserve, Haver Analytics, * Federal Reserve, BoJ, ECB



Source: Federal Reserve, July 2013



Investors are more total-return-oriented and more diffuse

Sources: Federal Reserve July 2013, Deutsche Bank, May 20 ,2015, Federal Reserve Flow of Funds, Haver Analytics

• The hold-to-maturity investor base is shrinking (in green below)

• However, Mutual Fund assets are far less concentrated



The old levered buyers are dead, long-live the new levered buyers.

16

• SIVs, leveraged loan funds at 10X, and most levered fixed income hedge funds are gone, but…

• Some unconstrained funds are nearly 2X levered to credit

Sources: Bloomberg



Mutual Fund ownership and herding: One view.

17

Sources: JP Morgan April 7, 2015,TRACE,, Lipper

Lipper note: Based on seven periods between 2012-2014 when the S&P500 moved more than 6% in a four week period



Another view: sensitivity to returns, not equities

Source: IMF Global Financial Stability Report, April 2015, Chapter 3: The Asset Management Industry and Financial Stability

VIX Returns Alpha



Less yield, more duration – easy to go negative.

19

Sources: Barclays Live



Other possible causes

20

1) Market Concentration: Name all the institutions that now go under the name Deutsche Bank.

2) Valuation Concerns:

- How many of you have valuation policies that have caused you to execute a trade for price discovery reasons?

- How have “illiquidity” designations in Funds shaped your portfolios? Has it increased the compensation you demand for less liquid names?

Banker’s TrustAlex BrownIrving TrustCJ LawrenceMorgan GrenfellScudderKemperAbbey LifeSal. OppenheimDeutsche PostbankGerman American Capital CorpJames D. Wolfensohn



Does TRACE suppress dealer willingness to trade?

21

• Sell-siders will tell you that TRACE reduces *reported* price dispersion, but also willingness to bid and trade, as replicated in a Harvard-MIT study.

• Do buy-siders believe this?


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Aggravating inventory re-pricing and performance risks to traders?

TRACE

Barclay’s Aggregate Risk/Return

Sources: Bloomberg, Barclays

1/1/89

8/1/89

3/1/90

10/1/90

5/1/91

12/1/91

7/1/92

2/1/93

9/1/93

4/1/94

11/1/94

6/1/95

1/1/96

8/1/96

3/1/97

10/1/97

5/1/98

12/1/98

7/1/99

2/1/00

9/1/00

4/1/01

11/1/01

6/1/02

1/1/03

8/1/03

3/1/04

10/1/04

5/1/05

12/1/05

7/1/06

2/1/07

9/1/07

4/1/08

11/1/08

6/1/09

1/1/10

8/1/10

3/1/11

10/1/11

5/1/12

12/1/12

7/1/13

2/1/14

9/1/14

0.0

0.5

1.0

1.5

2.0

2.5

2.19

2.07

1.76

1.51

1.18

0.38

Aggregate Bond Index Yield-to-Worst/Modified Duration

Lehman Bankruptcy

Interest Rates and Corporate Bond Returns

Sources: Bloomberg, Barclays

-6% -4% -2% 0% 2% 4% 6% 8% 10% 12%-10%

-5%

0%

5%

10%

15%

f(x) = 1.09697260086316 x − 4.01521906772933E-05R² = 0.710514350152147

U.S. Corporate Bond Index

U.S. Treasury Monthly Return (%)

U.S.

Cor

pora

te M

onth

ly R

etur

n (%

)

-6% -4% -2% 0% 2% 4% 6%-20%

-15%

-10%

-5%

0%

5%

10%

15%

f(x) = 0.0977509700112443 x + 0.00717813316917613R² = 0.00310153693976412

U.S. High Yield Bond Index

U.S. Treasury Monthly Return (%)

U.S.

Hig

h Yi

eld

Mon

thly

Ret

urn

(%)

05/01/2023 Source: Bloomberg 26

1000 1200 1400 1600 1800 2000 220050

60

70

80

90

100

110

120

130

140

150

Series1; 64

f(x) = − 0.0711935644046267 x + 212.775800339838R² = 0.654666109346649f(x) = − 0.0265917199422584 x + 115.155084811054

R² = 0.220126120587593

f(x) = − 0.0623874618482483 x + 181.745844624778R² = 0.71501973378967

f(x) = − 0.163083851484907 x + 327.45594734216R² = 0.613953860816319

f(x) = − 0.268821597004459 x + 446.669158792764R² = 0.707329445350594

Investment Grade CDX Spread to the SPX by Year2011 Linear (2011) 2012 Linear (2012) 2013 Linear (2013)2014 Linear (2014) 2015 Linear (2015) Last

SPX

CDX

IG C

DSI G

EN 5

Y SP

RD

Sources: Bloomberg, Barclays, Federal Reserve

0

50

100

150

200

250

205

12141726

404542

57

74

39 39

Value of Barclay's U.S. Corporate Bonds as Mul-tiple of Primary Dealers Inventory

Mkt

Val

ue/D

eale

r Pos

iton

Mul

tiple

Dodd-Frank Executed

Dodd-Frank Effective

Lehman Files

05/01/2023 Source: BAML 28

Jan-9

8Ju

l-98

Jan-9

9Ju

l-99

Jan-0

0Ju

l-00

Jan-0

1Ju

l-01

Jan-0

2Ju

l-02

Jan-0

3Ju

l-03

Jan-0

4Ju

l-04

Jan-0

5Ju

l-05

Jan-0

6Ju

l-06

Jan-0

7Ju

l-07

Jan-0

8Ju

l-08

Jan-0

9Ju

l-09

Jan-1

0Ju

l-10

Jan-1

1Ju

l-11

Jan-1

2Ju

l-12

Jan-1

3Ju

l-13

Jan-1

4Ju

l-14

Jan-1

50

20

40

60

80

100

120

140

160

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

11

102

9

136

11

20

37 37

2.14%

13.69%

15.25%

1.78%

Merrill Lynch U.S. High Yield Annual Defaults#US Defaults in LTM Average

Last

12-

Mon

ths

Num

ber o

f U.S

. Def

aults

(#)

Def

ault

Perc

enta

ge o

f Tot

al Is

sues

(%)


1-Apr

12-Apr

23-Apr

4-May

15-May

26-May

6-Jun17-Ju

n28-Ju

n9-Ju

l20-Ju

l31-Ju

l

11-Aug

22-Aug

2-Sep

13-Sep

24-Sep5-O

ct

16-Oct

27-Oct7-N

ov

18-Nov

29-Nov

10-Dec

21-Dec

$4,800

$5,000

$5,200

$5,400

$5,600

$5,800

$6,000

$6,200

$6,400

$15,000

$16,000

$17,000

$18,000

$19,000

$20,000

$21,000

$22,000

$23,000

$24,000

$25,000

IG Credit ETF Market CapsIntermediate IG Longer Dated IG

(Mill

ions

$)

(Mill

ions

$)


4/30 5/75/14

5/215/28 6/4

6/116/18

6/25 7/2 7/97/16

7/237/30 8/6

8/138/20

8/27 9/39/10

9/179/24

10/110/8

10/1510/22

10/2911/5

11/1211/19

11/26$0

$100,000,000

$200,000,000

$300,000,000

$400,000,000

$500,000,000

$600,000,000

$700,000,000

$800,000,000

$900,000,000

$1,000,000,000

$1,100,000,000

$1,200,000,000

$1,300,000,000

$1,400,000,000

Transitional Corporate ETF HoldingsLong IG Corporate ETF Intermediate IG Corporate ETF


Apr-13Apr-1

3Apr-1

3Apr-1

3

May-13

May-13

May-13Jun-13

Jun-13Jun-13

Jun-13Jul-1

3Jul-1

3Jul-1

3

Aug-13

Aug-13

Aug-13

Sep-13

Sep-13

Sep-13

Sep-13

Oct-13Oct-

13Oct-

13

Nov-13

Nov-13

Nov-13

Nov-13

Dec-13

Dec-13

Dec-13

$100

$105

$110

$115

$120

$125

2240

2260

2280

2300

2320

2340

2360

2380

2400

2420

IG Corporate ETF Price PerformanceMilestones Intermediate Corp IGLong Corp IG ETF Barclays Intermediate Credit Index

ETF

Shar

e Pr

ice

Barc

lays

Inde

x Va

lue

Purchase 1st Sale Closed Out


Jul-13 Sep-13 Nov-13 Dec-13 Feb-14 Apr-14 May-14 Jul-14 Aug-14 Oct-140

200

400

600

800

1000

1200

25000

2500025000 25000

25000

2500025000

2500025000

25000 2500025000

25000

2500025000

25000

25000

25000

25000

25000

2500025000

25000

25000

25000

25000

25000

Fiscal 2014 Monthly Mandate Size &PerformanceC.Rates Rates Benchmark TransitionTransition Benchmark Credit Credit Benchmark

Fisc

al Y

ear t

o Da

te P

efor

man

ce (b

ps)



E-trading: phantom liquidity?

Sources: Federal Reserve, July 2013; Market Axess, 2013 date is annualized from 1H* Uses single dealer date thought to be representative of broad market

Much volume, little depth


“BBH” and “BBH & Co.” are registered service marks of Brown Brothers Harriman & Co.

Hedging Possibilities

• Prohibitively priced, in carry terms

35

-6

-4

-2

0

2

4

6

300 320 340 360 380 400 420 440 460 480 500 520

Excess Return (%)

CDX.HY spread at maturity (bp)

CDX High Yield Swaption

No Option

-10

-20

-30

-2.0

0.0

2.0

4.0

6.0

8.0

-200

-150

-100 -5

0 0 50 100

150

200

250

300

350

400

450

500

Mill

ions

10-Year Yield Change (Bps)

1-Year 3% Strangle on 10-Year Treasury Futures

5% MV

10% MV

20% MV

• Sources: BBH Analysis; Bloomberg



What are we doing?

36

• “War gaming” liquidations

— Large idiosyncratic liquidations

— Market stress

• Reviewing liquidity policies in portfolio management

• Considering impact on valuation policies

— Fund valuation vs. liquidation price

• Examining prospectus language and legal framework to understand options

• Talking to other Fund Groups to understand their approach

• Looking into reverse repo/credit lines

— Committing a credit line would have a performance impact

— Reverse repo markets exist, but likely not when you needed them

• Discussing business implications with Treasury



Estimate of price impact of liquidation

37

• Trader estimates, line-by-line, of liquidation impact based on trading immediately, or over two weeks (“extended liquidation”).

• Crisis-level stress is 5-8X the market impact.

Tiers Structured Corporates Municipals Cash/CEQ Total

0-5bps 20.75% 6.90% 2.62% 18.31% 48.58%

5-25bps 19.92% 20.03% 0% 0% 39.95%

>25bp 5.55% 5.92% 0% 0% 11.47%

Enhanced Cash Liquidity Tiers

Tiers Structured Corporates Municipals Cash/CEQ Total

0-5bps 10.02% 0% 6.92% 7.50% 24.44%

5-25bps 17.80% 19.03% 0% 0% 36.83%

>25bp 10.75% 27.98% 0% 0% 38.73%

Credit Value Fund – Liquidity Tiers

Short LiquidationPeriod

Extended Liquidation Period

Total Fund Impact -0.33% -0.18%

Corporates -0.19% -0.12%

Total Structured -0.14% -0.06%

ABS -0.11% -0.05%

CMBS -0.03% -0.01%

Muni -0.01% -0.01%

Enhanced Cash Price Impact

Short LiquidationPeriod

Extended Liquidation Period

Total Fund Impact -1.42% -0.76%

Corporates -1.07% -0.52%

Total Structured -0.31% -0.18%

ABS -0.24% -0.16%

CMBS -0.07% -0.03%

Muni -0.04% -0.04%

Credit Value Fund (Fund Price Impact)



Liquidation terms

38

UCITS• “Prospectus provides that if investors seek to redeem more than 10% of the NAV of any sub-fund on any

given day, the Fund reserves the right (subject to Board approval) to scale down pro rata each redemption request so that no more than 10% of the Fund's NAV is redeemed on such day. “

40 Act• “For 40 Act Funds, the Fund is required to redeem out shareholders on the date a redemption request in

good order is received. The Fund has the ability to suspend cash settlement for up to 7 days, except (1) for any period where the NYSE is closed or trading on the exchange is restricted, (2) for any period during which an emergency exists as a result of which (A) disposal by the Fund of securities owned by it is not reasonably practicable, or (B) it is not reasonably practicable for the Fund fairly to determine the value of its net assets, or (3) for any period as the SEC may by order permit. The only other alternative for large redemptions is a redemption in-kind. “

• The fund may stop redemptions only by a Board vote

Credit Value Fund – Private• Private partnership, monthly exit with 10 calendar days notice prior to month end and significant settlement

lag after NAV is struck

• High degree of redemption flexibility for us, but also a much greater degree of illiquidity and non-distributable assets within the Fund.



Alternatives

39

Delayed Settlement• Our colleagues experienced this ourselves selling a small portion of the XXXXXXX High Yield Fund.• 40 Act suggests a 5-day window.• If we don’t manage to sell enough on the initial redemption date, the price impact of liquidation falls on the

remaining shareholders.• There does not appear to be a valuation approach we can take on the redemption date to mitigate this.

Delayed Redemption• 40 Act law prohibits this absent a board resolution to suspend.• UCITS funds can limit daily redemptions to 10%.

Redemption-in-kind• Last option. We can liquidate these assets far more effectively than small shareholders.• We don’t know whether disribution of 144a, illiquids, and loans is even possible.• We can think of potential mechanisms to help with this (e.g. a trust/escrow) but don’t know if they are legal

or feasible.

Borrowing via reverse repo, credit line, overdraft• Reverse may not be available in low liquidity market.• Both options leverage the remaining shareholders to the more concentrated fund.



Credit Lines

40

• Fund-level loans typically against pools of IG bonds (X-Bank)

— Start around $50-100mm, growing to $500mm over time

— Haircut 10-25%

— 1-3 month drawings

— Drawn 1-mo LIBOR+100-130 bps

— Undrawn: 20-30 bps

— Callable with 15-25% NAV declines

• Larger unsecured syndicates

— 4-10 bps commitment; L+75-100 drawn

• For Enhanced Cash the X-Bank facility doesn’t seem very useful. It is expensive on an ongoing basis and very limited protection against a tail event.

• Default O/D rate from Custodian = L+200, very large funds have negotiated better O/D pricing.

The views expressed are as of May 2015 and are a general guide to the views of Brown Brothers Harriman (“BBH”). The opinions expressed are a reflection of BBH’s best judgment at the time of this interview and was conducted and any obligation to update or alter our views as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, or markets generally.



lashantz - fixed income leaders combined presentation v.20150604

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