Liquidity is a good thing – and it has value. But, the ability to cheaply and easily convert an investment into cash often comes at a steep price. If you are a patient investor with a long time horizon, you may be able to get better returns if you relinquish some of that liquidity. The reason: The liquidity premium. That is, the extra money investors are willing to pay up front to invest in a security that they can easily liquidate. And, as we all know, the more you pay for an asset, the lower your expected returns must be, all other things being equal.
To understand how it works, imagine a company that wishes to raise $2 million in debt capital. They anticipate that the cost of raising this capital – that is, the interest rate they pay out, will be about $160,000 per year, or 8 percent on the total amount raised, and they budget for that amount. (See Exhibit 1)
|ISSUE A||ISSUE B|
|Funding Goal||$1 million||$1 million|
|Type||Publicly traded bond||Private placement debt offering|
|Expected annual cost of capital||$80,000||$80,000|
|Amount actually funded||$1 million||$800,000|
|Actual interest rate||8 percent||10 percent|
The Board of Directors elects to float a $1 million bond – “Issue A,” that is easily tradable in the secondary market. Issue A, a publicly traded bond, is offered over one of the major exchanges. There is a willing market for the company’s bonds, and they trade every day in adequate volume. Anyone wanting to sell his or her bonds and receive the cash can do so quickly and easily.
The Board of Directors also elects to raise the remaining $1 million via a private placement debt offering – “Issue B.” In this case, Issue B is not readily sellable. If the lender wanted to cash out his position, it could take a while to find a buyer.
Remember, it is the same company issuing both Issue A and Issue B, thus default risk is identical in both cases. The only difference between the two issues is liquidity: Issue A is much more liquid than Issue B.
“If an investor is willing to use a slow-cooker approach to investing, as opposed to a microwave strategy, the rewards can be substantial.”
Which issue is likely to have the higher interest rate? Well, in theory, they both have the same intrinsic value – if you regard value as the discounted present value of future cash flows. In practice, issue B will almost always have the higher yield to maturity.
If the two bonds were precisely equal and priced at the same point – exactly at par value with identical coupon rates, investors would flock to Issue A rather than Issue B. After all, why lock up your money for months or years if you do not have to? If the company wants to attract capital to Issue B, it must offer something to compensate these private placement debt investors for tying up their capital for a while. Conversely, if investors are going to be willing to commit their capital for a period of time, then they will demand something in return. Since seniority, default risk and everything else about the two securities is identical, then investors considering Issue B will demand a better interest rate.
Here is how it may work: The company markets Issue A, its publicly traded bonds, offering an 8 percent coupon rate, as planned. The issue is successful, and the company raises $1 million, as planned. Investors buying the newly issued securities also receive the 8 percent, and can easily liquidate their holdings.
But, the company quickly finds out that Issue B isn’t selling so quickly. Investors wouldn’t commit their money without compensation in the form of a higher interest rate. So the company must offer a higher interest rate: 10 percent rather than 8 percent in this example. Yes, the company will either have to budget more money to pay interest on Issue B if it wants the full million dollars planned, or it will have to make do with $800,000 instead of $1 million. But the fact remains that investors who are not concerned with short-term liquidity were able to get a much better deal than investors who went with Issue A.
Yes, liquidity has value – to those who need it. If you expect you may need to cash out your investment within a few years – or before the bond matures – then it may be worth it to take the lower expected return of an easily-traded security or bond.
If you are confident that you will not need to liquidate your investment for at least as long as the maturity on the bond, then there’s no reason to settle for the lower return. You are likely better off with the superior returns available via Issue B – the private placement debt offering.
In short, if the investor is willing to be patient – to use a “slow cooker” approach instead of a “microwave investment” style – the rewards can be substantial.
Paying a premium for liquidity you do not need can reduce your long-term return on an investment by 25 percent or more. For example, a 2005 study by Long Chen of Michigan State University found that this illiquidity discount alone accounted for as much as 22 percent of the difference in performance between similar high-yield bond issues. “An increase in illiquidity is significantly and positively associated with an increase in yield spreads, regardless of controlling for changes in credit rating, macro-economic influences or firm-specific factors,” the researchers wrote.
Furthermore, a 2001 study, using different methodology, found an average illiquidity advantage for investors of 9.83 percent for private placements. A survey of 2007-2008 transactions conducted by Trugman Valuation Services found that illiquid issues had an implied discount of 18.1 percent (14.4 percent median).
This is why many investors with longer time horizons are not well served by traditional brokerage firms. Many mass-market brokerages simply do not have access to private placement debt offerings of this type. Or, they may not be able to serve higher net worth, accredited investors efficiently because of their business model.
These non-publicly traded and/or private placement debt offerings are subject to a variety of risks. First, liquidity is very low, and in some cases practically nil for several years, and possibly until maturity. This is why they generally pay a much better interest rate than comparable highly liquid publicly-traded bonds.
Second, while underwriters have every expectation of success, depending on the nature of the bonds, there can be other risks, such as: construction delay or overruns; marketing problems; property issues and legislative risk. Each investor is advised to read the prospective that accompanies the bonds in detail and to discuss with their advisor. As such, these investments are suitable only for experienced, accredited investors – those with a relatively high net worth and little need for immediate income from this capital. Under current regulations, an individual is considered an accredited investor if that individual has a net worth, excluding his or her primary residence, of more than $1 million, either alone or together with a spouse. Alternatively, an individual can qualify for accredited investor status if he or she has income exceeding $200,000 (or $300,000 together with a spouse) for each of the two prior years, and has a reasonable expectation of earning at least that amount in the current year.
Additionally, these non-publicly-traded private placement issues or securities are normally suitable only for those accredited investors who have longer time horizons and therefore are under little pressure to liquidate their investments to meet expenses for some time.
For more questions about liquidity or generating income, contact your HJ Sims advisor today.
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The opinions expressed by Mr. Van Steenwyck and Mr. Richard are strictly their own and do not necessarily reflect those of Herbert J. Sims & Co., Inc. or their affiliates. This is not a solicitation to buy or an offer to sell any particular investment. All investment involves risk and may result in a loss of principal. Investors should carefully consider their own circumstances before making any investment decision.
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