Lesson 17 of 25 · 7 min
A flight to quality, stated in collateral terms
The gap between schedule rows widens more than any single row moves, so two portfolios of equal size stop being equal collateral.
A flight to quality is usually described as money moving from one kind of asset to another. Described in collateral terms it is something more specific: the distance between the rows of a schedule widening.
What happens underneath is a change in what buyers insist on. Demand concentrates in whatever is most certainly saleable tomorrow. Government-backed and short-dated instruments hold their price or rise. Broad, deep equity holds up better than narrow equity. Thin and complex instruments lose the price and the bid together. A lender watching this revises its rows in the same order, because the ordering it observes is an ordering of liquidation risk.
One illustrative set of revisions published in a single week:
- A government bond fund row: 80 percent down to 78.
- A broad equity row: 70 percent down to 64.
- A mid-sized company row: 55 percent down to 42.
- A thinly traded small-company row: 35 percent down to nothing.
The top row moved two points and the bottom row moved thirty-five. Apply that to two portfolios each worth $1,480,000. The first, weighted 60 percent broad equity, 25 percent bonds and 15 percent mid-sized, loses 8.17 percent of market value and 15.00 percent of lending value. The second, weighted 20 percent broad equity, 45 percent mid-sized and 35 percent thin, loses 23.15 percent of market value and 47.88 percent of lending value. Equal wealth at the start; $883,759.80 of capacity against $393,369.20 at the end.
One qualification, because it looks like a contradiction and is not. A flight to quality is about what buyers want. A cash squeeze is about what sellers can sell, and Track 11's March 2020 lesson shows that a fund raising cash sells the liquid part, which can push high-quality prices down for a period. The two are different mechanisms that can run at the same time, and the second is usually the shorter of the two.
Key terms
- Flight to quality
- A shift in demand towards the most certainly saleable assets, which raises their price and withdraws the bid from everything else.
- Dispersion of advance rates
- The spread between the most and least generous rows of a schedule. It widens in a tightening far more than the average row moves.
- Quality ladder
- The ordering of assets by how certainly they can be sold. Lenders revise rows in this order because it is the order that predicts liquidation cost.
Worked example
Two portfolios of the same size, one event
Illustrative figures. Each portfolio is worth $1,480,000. Price moves: broad equity minus 9 percent, bonds plus 1.5, mid-sized minus 21, thin small-company minus 34.
- Portfolio one, lending value before
- $1,039,700
- Portfolio one, after
- $883,759.80
- Portfolio two, lending value before
- $754,800
- Portfolio two, after
- $393,369.20
- Ratio of capacity, before and after
- 1.38 to 1, then 2.25 to 1
60/25/15 across broad equity, bonds, mid-sized.
Market value minus 8.17 percent, lending value minus 15.00.
20/45/35 across broad equity, mid-sized, thin.
Market value minus 23.15 percent, lending value minus 47.88.
The gap in market value roughly doubled. The gap in borrowing capacity widened by more, because the schedule amplified the ordering the market had already produced.
Check yourself
A $960,000 portfolio is split evenly between a broad equity fund and a thinly traded small-company share. Broad equity falls 9 percent and its row goes from 70 to 64; the thin holding falls 34 percent and its row goes to nothing. What happens to market value and to lending value?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.