This month’s ALM Insights is a return to one of my favorite topics, bond market liquidity. In the September 2013 issue I wrote Liquidity as a Risk Factor – which highlighted the impact that liquidity can have on expected return. I wrote on liquidity again in the June 2015 issue in Is Bond Market Liquidity Gone? – where I looked into how market liquidity can change over time. Well the topic is getting attention again, this time in the area of regulation.

The regulation in question actually has no direct implication for community banks. The Liquidity Coverage Ratio requirement mandates the largest banks in the country to hold enough High-Quality Liquid Assets to cover 30 days of outflows. Being debated is whether municipal bonds can be considered High-Quality Liquid Assets.

Per Basel III regulation there are three categories of High-Quality Liquid Assets. Level 1 has no haircut and includes things like Treasury Bonds. Level 2A has a 15% haircut and includes bonds issued by Fannie Mae and Freddie Mac. Level 2B has a 50% haircut and includes some of the most liquid common stocks and corporate bonds issued by non-financial companies. Initial versions of the regulation left municipal bonds out completely, but some changes recently introduced by the Federal Reserve propose including select municipal bonds alongside certain non-financial corporates in Level 2B.

I don’t want to spend a ton of time on the regulation itself, because it doesn’t have a direct impact on our clients, but it does give us the opportunity to look at the differences in the liquidity of certain kinds of bonds and how that effects the role they play in the portfolio.

Quality trading data is hard to come by for the muni bond market but here are some data points…

• According to a study by the SEC about 70% of municipal issuers had no trades in their securities for the period between December 12, 1999 and November 5, 2000.
• The unique municipal bonds that do trade, trade on average 1.5 times per year.
• In 2011 about 99% of outstanding municipal securities did not trade on any given day.

Because each bank treats their securities portfolio differently, there are cases where municipal securities make a lot of sense. Assuming the tax free income is useful to the bank, they can be a great source of higher expected returns. Because they are credit sensitive securities that have the potential to behave differently than other credit exposure on the bank’s balance sheet they can be a great source of diversification. However, very rarely do they provide liquidity to an investor at the level that Treasury, Agency or even specified mortgage pools can.

One useful strategy may be to determine the liquidity need for the bank and invest the excess in less liquid alternatives like muni bonds to target higher returns over time. If there is no excess, then you are probably better off not investing is the asset class at all. Liquidity is one of those things that you don’t need until you really need it… and then you REALLY need it.

Getting back to the regulation – I agree with the first version that didn’t allow for banks to consider muni bonds as High-Quality Liquid Assets. I don’t want the biggest banks being forced to look to illiquid parts of their bond portfolios to raise cash in a crunch, and I don’t want community banks to either.