Liquidity-First Bond Selection Rule
Favor large, widely held bonds that preserve an exit path
- Difficulty
- Easy
- Time to result
- ~days to results
- Steps
- 6
- Confidence
- 95%
The Liquidity-First Bond Selection Rule makes future exit capacity a prerequisite for purchase rather than an afterthought. Because individual bonds may lack continuous bids and dealers now carry less inventory, the manager favors large global issues held by many investors. LM Capital described seeking issues of at least roughly one billion dollars and avoiding smaller bonds whose extra yield mainly compensates for limited market depth. The rule also considers the firm's intended trade size: a smaller manager moving ten or twenty million dollars may find counterparties more easily than a giant fund moving hundreds of millions. The output is a portfolio with broader potential ownership and a better chance of being repositioned when conditions change, even if it sacrifices some headline yield.
Origin
Luis Maizel described LM Capital Group's response to declining dealer inventories and the bond market's uneven liquidity on Masters in Business.
Core principles
- 01Treat the ability to exit as part of credit selection
- 02Prefer large global issues with broad ownership
- 03Reject small-issue yield premiums that compromise liquidity
- 04Match position size to realistic market depth
- 05Accept slightly lower yield when it materially improves optionality
How to run it
- 1
Set the liquidity requirement
Define how quickly and in what size the portfolio may need to sell a holding. Relate the requirement to client redemptions and portfolio risk limits.
Pro tip Use stressed rather than normal trading assumptions.
Watch out Historical volume may overstate liquidity available during a selloff.
- 2
Screen for issue size
Favor large global offerings with enough outstanding principal to attract broad institutional ownership. Use roughly one billion dollars as the transcript's example threshold.
Pro tip Compare issue size with the position the portfolio intends to hold.
Watch out A large issue is not automatically liquid if ownership is highly concentrated.
- 3
Assess breadth of ownership
Determine whether the issuer and bond are names that many investors want in their portfolios. Broader ownership creates more potential counterparties.
Pro tip Look for participation across regions and investor types.
Watch out Popularity can disappear during issuer-specific distress.
- 4
Test the exit path
Estimate who could take the other side of a sale and how long execution might require. Consider the reduced willingness of dealers to warehouse inventory.
Pro tip Ask traders for executable depth, not only indicative pricing.
Watch out A quoted price does not guarantee that the full position can trade there.
- 5
Compare yield with liquidity cost
Identify how much extra yield comes from the issue's smaller size or poorer liquidity. Reject the trade when that premium does not compensate for impaired exit flexibility.
Pro tip Express the added yield against a comparable large issue from the same risk category.
Watch out Small yield differences can vanish in one costly exit.
- 6
Size the position conservatively
Keep the holding small enough that the portfolio can transact without requiring an unusually large counterparty. Reassess liquidity as assets under management change.
Pro tip Reduce position size before liquidity becomes urgent.
Watch out A security appropriate for a small fund may become unsuitable as the fund grows.
In the wild
A manager compares two bonds from similarly strong issuers. A small issue offers a modestly higher yield, while a billion-dollar global issue is held across many institutional portfolios. Applying the rule, the manager chooses the larger issue because it provides more potential counterparties if the portfolio must sell.
→ The portfolio sacrifices a small yield premium in exchange for a more credible exit path.
A portfolio wants exposure to an emerging-market corporate bond but discovers that its intended position would represent too much of normal market depth. Instead of assuming a dealer will warehouse the sale later, the manager reduces the purchase to a size likely to find a counterparty.
→ The position remains tradable without dominating the issue's available liquidity.
Common mistakes
Chasing the small-issue premium
A few additional basis points may not compensate for the inability to exit when buyers disappear.
Assuming dealers hold inventory
Post-crisis dealers often seek an immediate buyer rather than carrying bonds on their own balance sheets.
Ignoring fund size
Liquidity depends on the amount being traded, so a bond that works for a small portfolio may not work for a very large one.
Is it for you?
Best for
It is best for active bond portfolios that value reliable repositioning more than small illiquidity premiums.
Not ideal for
It is not ideal for locked-up strategies deliberately designed to harvest illiquidity premiums over long holding periods.
From the transcript
“What we tried to do is buy global issues, very big issues that a lot of people holding their portfolios.”
“We go for the billion dollar issues at least, and we want the names that people want to hold in their portfolio.”
“We don't like that. We want to have the ability to get out whenever we want.”
From the episode
Luis Maizel Discusses Diversity in Finance
Luis Maizel