Many investors have found it challenging to generate yield in a “low for long” interest rate environment. Not surprisingly, this topic often comes up in our casual conversations with limited partners. As a service to our constituents we decided to not only explore what has been happening in the credit markets, but also provide some ideas on where they can find yield. These learnings also help Virgo and its portfolio companies plan for strategic initiatives in 2016, such as the level of debt available to help fund add-on acquisitions.

In the spirit of holiday giving, we would like to share some of these findings with our Virgo View readers. Happy Holidays!

Non-Newtonian Liquid(ity)
November 30, 2015

Last week my youngest child (who recently turned three!) came home from Kids Science Lab constantly trying to say ‘Non-Newtonian liquids’. After the shock wore off (and a quick Google search), I discovered not only what he was learning about – liquids that change their behavior under stress, like Oobleck – but also a fitting title for this memo.1

To casual market observers and participants, U.S. debt and equity markets have been open for business and operating normally throughout 2015. Equity underwriting (YTD through Oct’15) is off only 13% from 2014’s record pace, while equity trading volumes are up across most major U.S. exchanges.2

On the debt side (which I’ll spend more time on given most of our LPs are searching for yield), a review of published market data also appears to support this view, though warning signs regarding debt liquidity have been raised throughout the year by firms like Oaktree3 and Goldman Sachs4. The most common concern cited has been the negative impact of the Volker Rules and Basel 3 on dealers’ willingness to serve as credit warehouses/ market makers for corporate bonds due to higher balance sheet charges. On the other side of the argument, institutions like the Federal Reserve Bank of New York have pointed to price-based liquidity measures (e.g. bid-ask spreads narrowing, price impact declining) to support the notion that credit markets are liquid and functioning normally.5

So, are U.S. credit markets liquid? Before answering that question, it is helpful to first determine what constitutes liquidity. The best definition of market liquidity I’ve found was one put forward by the Head of the Monetary and Economic Department at the Bank for International Settlements.6 He defines market liquidity as having four dimensions:

1. Tightness – difference between buy and sell prices.
2. Depth – size of transactions that can be absorbed without affecting prices.
3. Resiliency – ease with which prices return to “normal” after temporary order imbalances.
4. Immediacy – speed with which orders can be executed.

I already noted the data behind the New York Fed’s view regarding tightness and depth above, though one could argue as Goldman Sachs does that gauging market liquidity solely on bid-ask spreads is “unconvincing” since it only captures the end result, and not the process leading up to the trade. To get a better view of this process throughout 2015, I spoke to a few friends who work on trading desks – what they had to say shined a light on divergent views among market players regarding liquidity.

Each trader I spoke to indicated that most days there were no issues with market resiliency and immediacy. Nonetheless there have been times throughout the year where executing larger trades have taken much longer than normal – sometimes multiple weeks versus a single day historically. This aligns with Goldman Sachs’ view that only focusing on tightness and depth metrics is misleading. More importantly, no one seems to really know the root causes of these intermittent periods of illiquidity. Put another way, liquidity has been changing its behavior under stress…but the stress is unknown.

Getting back to the core question of whether U.S. credit markets are liquid, my current view is ‘Yes’ but thinning liquidity will provide less resistance to potential market stress (increasing the probability liquidity freezes, which of course can cause asset prices to collapse). While liquidity risk is always present in the market, I believe a few factors today exacerbate the issue. If hedge funds are indeed picking up the liquidity slack from corporate bond dealers, who will step in if a market shock induces selling among the majority of these firms? In addition, hedge fund capital bases are relatively more sensitive to mark-to-market losses, which can turn them into forced sellers irrespective of their conviction due to investor redemption requirements. This can lead to a vicious cycle in crowded positions (such as energy in Q3). Bond portfolio managers also have been plowing money into bond ETFs to avoid trading the underlying “illiquid” assets. However as Oaktree pointed out in the aforementioned memo, ETFs provide the illusion of liquidity as no investment vehicle can be more liquid than its underlying instrument.7

Is it time to start “hiding cash under the mattress?” While it makes sense to deleverage when liquidity is thin(ning), there are (increasingly) attractive yield opportunities if you know where to buy it or how to build it. I detail three strategies to explore (individually or through funds) below:


In summary, the thin(ning) liquidity environment creates attractive high yield opportunities for those willing to search/ work for it. Given the choice, I recommend building yield (by structuring deals where you can be a price setter) versus buying yield (where you are a price taker).

Do not hesitate to contact any of us here at Virgo Capital if you have any questions or would like us to evaluate an investment opportunity for you in more detail.

Finally, to our (Japan) U.S. LPs I hope you all had a good (勤労感謝の日) Thanksgiving Day!

1 As a Star Wars nut fan I was really hoping to use ‘Episode MMXV – High Yield Awakens’ given the U.S. high yield bond market delivered its strongest monthly return in October since early 2012. However it felt misleading and premature given higher rated securities led the way (outperforming their lower-rated peers) and new issuance volumes are still relatively low.
2 Source: Securities Industry and Financial Markets Association (SIFMA)
3 Read or download Howard Marks’ memo to Oaktree clients regarding liquidity here:
4 Read Charlie Himmelberg’s note to Goldman Sachs clients here:
5 Read the Federal Reserve Board of New York rationale here:
6 Source: Borio, Claudio, Market liquidity and stress: selected issues and policy implications, BIS Quarterly Review (November 2000).
7 ETF companies appear to understand this risk as they have been upping the capacity of their bank credit lines. BlackRock has gone the extra step of seeking permission from the SEC to set up an internal lending program to temporarily borrow money from sister funds that have excess cash ( Let that soak in for a moment. The counterparty risk of this “borrowing from Peter to pay Paul” strategy should worry investors in BlackRock’s “less risky” funds (e.g. Treasuries) as they are effectively providing leverage to investors in BlackRock’s “riskier” funds (e.g. corporate bond ETFs) that have a higher probability of redemptions.