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Beware the illiquidity delirium when buying-up credit

Bond markets might be offering comparable returns to equities and a higher place in the capital structure, but they should be approached cautiously as they lack what institutions around the world are trying to maintain – liquidity.

Equity markets have been sold off and tapped for liquidity, but unlike corporate bond markets, they remain a place where sellers can meet willing buyers.

Bob Jaeger, senior market strategist with BNY Mellon Asset Management, says investors should not let the concept of an illiquidity premium lure them into the bond market.

“Just because something is less liquid doesn’t mean it will earn a bigger return,” Jaeger says.

“Equities have already absorbed a huge amount of selling. In the bond market, the supply is enormous, and we still don’t know what demand there will be and whether buyers and sellers will meet at a price.”

The nod towards equities was made amid the “worrying” bear market rally from March into April, spurred on by decent economic numbers from the US and a few pieces of good news from the banks.

Even though Jaeger viewed credit markets as being healthier than stockmarkets, the “huge liquid market” for equities was a determining factor.

He said positive outcomes from the Troubled Asset Relief Program – or “great US experiment” – would be crucial to achieving stability in financial markets.

But it was uncertain whether buyers, who have been offered very attractive pricing terms, and sellers would be able to agree on valuations, since the banks would hold out for the highest possible price, and sellers push for the lowest.

“We’re just now getting to what will be the most difficult part of the exercise:  when banks make first transactions on these toxic assets – not marking-to-market, but the real deals. It’s crunch time.”

To progress, the program could require further government intervention.

“At some point, Washington might have to say to the banks: “You have to take the short-term pain. “The sooner banks do so, the sooner other people will want to invest in them.

“Markets are looking for real information and positive action, but don’t want that information to be a denial of reality, which was the Japanese nightmare.”

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