The credit crunch caused by the US sub-prime market crisis brought home to investors that bond funds, too, can be volatile and even relatively illiquid.

What Stacy Scapino, the Chicago-based global director for the Mercer Sentinel Group, brought home to conference attendees was just how illiquid fixed interest can be in times of crisis.

In an address on the risks associated with some securities lending programs, Scapino said that when liquidity associated with various instruments declined substantially last year, credit risk increased, requiring collateral upgrades and/or switches. However, while this presented challenges to the lenders and their agents, it also presented opportunities.

She suggested the lenders should:

  • Keep utilisation rates up
  • Take advantage of market conditions for reinvestment without realising losses on existing positions.
  • Adequately measure the credit risk exposures, and
  • Manage credit risk exposures in volatile markets.

Scapino quoted a view from a lender published in Global Pensions magazine last month, which, while it might be commonly held, was erroneous in times of crisis: “The question I asked … in August or September was: ‘If you had a major liquidity crunch tomorrow, what would happen?’ The answer was that they could liquidate 70 per cent of the portfolio in three hours, another 20 per cent within a day and the rest within three to five days. ‘Our reinvestment is primarily in highly liquid, high quality investments. There are some lower quality issues in there (but) if it went upside down, as long as we’re not forced to sell, we will make good at maturity.”

Scapino said the actual time it took to trade in a liquidity crunch was much longer, or with far greater discounts than the above quote represented, or both. She questioned the indemnification protection offered by collateral, partly because of the physical processes involved in enforcing the indemnity. “To go from default to bankruptcy takes time,” she said.

There were often variables such as differing points at which the loan might be valued for indemnification, whether non-cash collateral was prohibited from liquidation and the indemnifier’s credit profile and capital coverage. She said that the lenders needed to analyse the contracts to decide whether they were engaging in a low-risk revenue source or what was more like a leveraged finance arrangement.

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