Managing Liquidity Buckets

Liquidity looks free until you need it. Fixed income funds suffered 12% outflows in a single month during March 2020—and the funds that hadn't pre-positioned liquid assets were forced to sell at the worst possible prices (Fed data, 2020). The point is: liquidity isn't about having "some cash." It's about segmenting your fixed income holdings by time horizon so you can meet obligations without fire sales, earn appropriate returns on longer-dated assets, and maintain discipline when markets stress.

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The Bucket Framework (Why Segmentation Works)

Liquidity bucket management divides fixed income holdings into tiers based on when you'll need the money. Each bucket accepts a different trade-off between yield and accessibility.

The core structure:

The trade-off chain:

Accessibility → Duration → Credit risk → Yield

Moving from Tier 1 to Tier 4, you accept less immediate access in exchange for higher expected returns. The discipline is resisting the temptation to stretch for yield in money you'll need soon.

Why this matters: The March 2020 crisis saw institutional investors with underfunded Tier 1 buckets forced to sell intermediate bonds at 5-10% discounts. Hedge funds' Treasury holdings declined $35 billion in Q1 2020 alone (NY Fed data, 2020)—much of it forced selling to meet margin calls.

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Sizing Your Buckets (The Calculation)

Bucket sizing depends on your liability profile. The goal is having enough in liquid buckets to cover known and stressed outflows without touching strategic holdings.

The framework:

Tier 1 (Operating):

• Base: 2-4 weeks of known expenses
• Buffer: +50% for unexpected needs
• Example: $50,000 monthly expenses → $100,000-$150,000 in Tier 1

Tier 2 (Reserve):

• Base: Known outflows for next 12 months
• Buffer: +20% for unplanned redemptions
• Example: $200,000 annual obligations → $240,000 in Tier 2

Tier 3 (Strategic):

• Base: Outflows from year 1-5
• Allow some duration exposure for yield pickup
• Example: $500,000 in 5-year liabilities → $500,000 in 3-5 year bonds

Tier 4 (Long-term):

• Remainder after Tiers 1-3 funded
• Can accept illiquidity premium
• Example: $1,000,000 remaining → long credit, private debt

Institutional example (pension fund pattern):

The Nordic Investment Bank (NIB) disclosed a structure of 37% short-term instruments (Tier 1-2) and 63% longer-dated bonds (Tier 3-4) in their liquidity management framework. This 40/60 split between liquid reserves and earning assets is common for entities with predictable but chunky outflows.

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Stress Testing Your Liquidity (The March 2020 Lesson)

The COVID-19 Treasury market stress (March 9-24, 2020) exposed liquidity assumptions that looked robust in normal times but failed under stress.

What happened:

• 30-year Treasury bid-ask spreads widened from 1/32 to 5/32—a 5x increase in transaction costs
• Fixed income fund outflows hit 12% of assets in one month
• The Fed purchased $775 billion in Treasuries and $291 billion in MBS between March 15-31 to restore market function
• Primary Dealer Credit Facility (PDCF) launched March 17 to provide emergency liquidity

The durable lesson: Your liquidity bucket sizing must account for stress scenarios, not just normal operations.

Stress testing framework:

The test: Can your Tier 1-2 holdings cover 6 months of obligations at 2x normal expense rate without touching Tier 3-4? If not, your liquidity cushion is too thin.

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Liquidity Classification by Instrument (What Goes Where)

Not all fixed income instruments are equally liquid. Classification matters more in stress than in calm markets.

Tier 1-eligible instruments:

• Cash and bank deposits
• Treasury bills (T-bills)
• Money market funds (government-only preferred)
• Overnight reverse repos

Tier 2-eligible instruments:

• Short-term Treasuries (1-3 year)
• Agency securities (Fannie, Freddie, FHLB)
• High-quality commercial paper (A1/P1)
• Certificates of deposit (brokered, negotiable)

Tier 3-eligible instruments:

• Intermediate Treasuries (3-7 year)
• Investment-grade corporates (BBB+ or higher)
• Agency MBS (specified pools)
• Municipal bonds (high-grade, general obligation)

Tier 4-eligible instruments:

• Long-duration Treasuries (10+ year)
• High-yield corporates
• Private credit
• Structured products (CLOs, CMBS)
• Emerging market debt

Why this classification matters: During March 2020, even on-the-run Treasuries experienced liquidity stress. If Treasuries can seize up, your corporate and structured holdings will be much worse. The practical rule: only instruments in Tiers 1-2 should be considered truly "liquid" for planning purposes.

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The Liquidity Premium (What You Give Up and Get)

Maintaining liquid reserves has a cost: you earn less than if you invested everything in longer-dated, less liquid instruments.

The trade-off quantified:

The paradox of late 2024: With an inverted yield curve, Tier 1 holdings actually yielded more than many Tier 2-3 options. This is unusual. In normal environments, you sacrifice 100-200 bps of yield by maintaining Tier 1-2 reserves.

The point is: Liquidity reserves aren't free insurance—they cost yield in normal times. But that cost is cheap compared to forced selling at distressed prices. The March 2020 investors who sold intermediate bonds at 5% discounts lost far more than any liquidity premium would have cost.

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Institutional vs. Individual Bucket Sizing

Bucket sizing varies dramatically based on liability structure and access to credit facilities.

Institutional investors (pensions, endowments):

Institutional investors often target 10-20% in Tier 1-2 combined, with the remainder in earning assets. The 2022 UK LDI crisis showed this can be too aggressive—UK pension funds faced margin calls requiring forced gilt sales of approximately 25 billion GBP in 5 weeks, with 30% of that selling occurring in just the first 5 days (Broadbent and Mayordomo, 2024).

Individual investors:

Individual investors should typically hold 3-6 months of expenses in Tier 1-2 regardless of portfolio size. This is higher than institutional ratios because you don't have credit facilities or predictable cash flows.

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The Refill Protocol (When and How to Rebalance)

Buckets deplete and refill as you spend and earn. Having a systematic protocol prevents both over-accumulation in Tier 1 (yield drag) and under-accumulation (liquidity risk).

The cascade model:

Inflows (dividends, coupons, contributions) → Tier 1 first → overflow to Tier 2 → overflow to Tier 3 → remainder to Tier 4

Tier refill triggers:

The practical rule: Review bucket levels monthly. Execute refill trades when any bucket is 25%+ above or below target. More frequent monitoring (weekly) during market stress.

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Detection Signals (When Your Liquidity Structure Fails)

Your liquidity bucket structure may be inadequate if:

• You sold long-dated bonds to meet short-term obligations (bucket mismatch)
• Your Tier 1 holdings earn significantly less than money market rates (wrong instruments)
• You don't know what percentage of your portfolio is in each tier (no structure)
• You've never stress-tested against a 2x expense scenario (untested assumptions)
• Your entire fixed income allocation could be called simultaneously (concentrated counterparty risk)

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Common Liquidity Mistakes

Mistake 1: Treating all bonds as liquid

Corporate bonds can gap 5-10% bid/ask in stress. Even Treasuries saw liquidity evaporate in March 2020. Only Tier 1 instruments (cash, T-bills, government money market) are truly liquid when you need them most.

Mistake 2: Ignoring the opportunity cost

Some investors keep 50%+ in cash equivalents, sacrificing 150+ bps annually "for safety." This over-liquidity costs real wealth over time. The goal is adequate liquidity, not maximum liquidity.

Mistake 3: Assuming credit lines will be available

During 2008 and 2020, credit lines were pulled or restricted precisely when investors needed them most. Don't count backup credit as Tier 1 liquidity—it's Tier 2 at best.

Mistake 4: One-time sizing

Liability profiles change. A pension fund with young participants has different liquidity needs than one making heavy benefit payments. Review bucket sizing annually or when circumstances change materially.

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Integration with Portfolio Rebalancing

Liquidity bucket management interacts with overall portfolio rebalancing:

The integration rule: Always process rebalancing transactions through the bucket framework. Don't simultaneously rebalance and spend from the same tier—you'll double-count the liquidity need.

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Mitigation Checklist (Tiered)

Essential (high ROI)

These 4 items prevent 80% of liquidity crises:

1. Define your tiers explicitly with dollar amounts and instrument eligibility
2. Size Tier 1-2 for 6 months at 2x normal expenses as stress buffer
3. Monthly bucket level review with refill triggers at 25% deviation
4. Only count Tier 1 instruments as truly liquid for immediate needs

High-Impact (workflow integration)

For investors who want systematic liquidity management:

1. Annual stress test against March 2020-level outflows and bid-ask widening
2. Cascade protocol for inflows: Tier 1 → Tier 2 → Tier 3 → Tier 4
3. Quarterly liability projection to catch changing liquidity needs

Optional (for institutional investors)

If you manage large pools with complex liabilities:

1. Model counterparty risk across Tier 2-4 holdings
2. Maintain contingent credit facilities (but don't count as Tier 1)
3. Separate liquidity stress testing from market risk VaR

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Next Step (Put This Into Practice)

Map your current fixed income holdings to the four-tier framework.

How to do it:

1. List all fixed income positions with current market values
2. Classify each position into Tier 1, 2, 3, or 4 based on the criteria above
3. Calculate the percentage in each tier
4. Compare to targets: 10-15% Tier 1, 15-25% Tier 2, 30-40% Tier 3, 20-40% Tier 4

Interpretation:

• Tier 1 below 10%: Liquidity risk—may face forced selling in stress
• Tier 1 above 20%: Yield drag—excessive cash earning less than possible
• Tier 4 above 50%: Illiquidity concentration—vulnerable to prolonged stress

Action: If any tier differs from target by more than 10 percentage points, schedule rebalancing within the next 30 days.

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References

• Duffie, D. (2020). "Still the World's Safe Haven? Redesigning the U.S. Treasury Market After the COVID-19 Crisis." Hutchins Center Working Paper #62, Brookings Institution.
• Logan, L. (2020). "Treasury Market Liquidity and the Federal Reserve during the COVID-19 Pandemic." Remarks at SIFMA, October 2020.
• Federal Reserve Bank of New York, "Treasury Market Liquidity During the COVID-19 Crisis," Liberty Street Economics, April 2020.
• Broadbent, J., and Mayordomo, S. (2024). "What Caused the LDI Crisis?" Bank Underground, Bank of England.
• Cambridge Associates, "Portfolio Liquidity Risk Management," 2023.
• CFA Institute, Fixed Income Portfolio Management Curriculum, 2024.