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How the Fed screwed up the bond market

*Biggest worry: Where are the sellers?
*High-yield market most at risk
*Roubini calls situation a "timebomb"

Live by central bank liquidity, die by central bank liquidity.

That could well become the mantra for a bond market that, after years of support by the Federal Reserve and its global counterparts, now finds itself suffering under the unintended consequences of the trillions in easing distributed to allay the fears of a market in crisis.

"Liquidity," in fact, is THE watchword now in bond trading—ironic, considering that the U.S. central bank's primary intention has been to boost the flow of cash through financial markets, drive a push toward riskier assets like stocks and corporate credit, and thus generate a wealth effect that would spread through the economy.

Indeed, stock prices have soared and high-yield aka junk has been one of the best places to be in fixed income, even if comparable U.S. and global economic growth has been absent. Companies already have issued more than half a trillion dollars in debt during a record 2015, convinced that investors will still have an appetite and rates will stay low.

But with the Fed looking for a spot where it can start tightening policy even as others are loosening and deflation fears dropping while inflation concerns grow, investors are getting the jitters.

What if, they wonder, rising rates make all that corporate debt look less attractive and spur a selloff? The scary answer, according to an increasing number of market experts, is a potential scenario where there's a rush to a door that is nailed shut. A huge number of sellers would be pouring into a market with a dearth of buyers, setting up a scenario where bond prices cascade and yields explode.

To be sure, these are all hypotheticals for now, and the bond market has overcome multiple bouts of nausea in the past six years, from 2013's "taper tantrum" to October 2014's "flash crash" and other hiccups before and after. But recent weeks have marked a heightened level of concern that the real challenges for the massive fixed income market are closer than any time since the financial crisis.

Economist Nouriel Roubini recently painted the picture of "a paradox" caused by "macro liquidity and market illiquidity."

"This combination ... is a timebomb," Roubini wrote in The Guardian. "So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets."

The Fed, for instance, pumped its balance sheet to $4.5 trillion through its monthly bond-buying program known as quantitative easing. The Bank of Japan is in the midst of its own QE money printing and is joined by the European Central Bank, which is also easing.

In turn, that created a rush to the bond market both for corporations and governments. However, increased regulation has chased many key buyers from the fixed income picture, creating a potential mismatch of buyers and sellers during times of crisis. One estimation, from Deutsche Bank, is that dealer inventories have declined as much as 90 percent since 2001.

Low yields and surging equity prices have provided a balm to the markets since the Fed went into ultra-easy mode in 2008. Stubbornly low yet consistent economic growth in the U.S. gave confidence to companies that they could market debt in seemingly limitless quantities, while short-term investors enjoyed the stock market gains.

However, the central bank-induced low rates and quiet optimism also have driven another trade—the quest for yield. In particular, investors grabbed onto high-yield debt, or "junk" as it is often called, despite its inherent risks.

Strategists at Bank of America Merrill Lynch put a fine point on the paradox of how central banks created both a liquidity solution and problem with their historically aggressive measures while they and congressional legislators created a tighter regulatory environment.

"Perhaps the biggest issue we have with high yield is that the asset class' performance has been driven over the last several years not by fundamental strength, but by QE and a lack of global yield," BofAML credit strategist Michael Contopoulos and others said in a note to clients. "In fact, the picture painted of the U.S. economy and of high-yield in particular is pretty bleak."

The Federal Reserve Building in Washington, D.C.
Getty Images
The Federal Reserve Building in Washington, D.C.

Contopoulos points to other worries in high-yield, such as lackluster corporate earnings in the space and an unwillingness to invest in capital, instead pumping money into stock buybacks and dividends. His language is strong, calling trends "very worrying" and pointing to "worsening fundamentals."

Investors have been reacting sharply as of late. Longer-term U.S. bond yields have spiked, with the benchmark 10-year edging toward 2.5 percent and the 30-year nearly 3.2 percent, though both pulled back Thursday.

In the corporate realm, trader behavior has shown an unmistakable trend of getting out of less liquid instruments and into more liquid ones like exchange-traded funds.

Even there, the trend has been unkind to high-yield.

Traders have pulled more than $1.8 billion from two junk-focused ETFs just in the past week: the iShares iBoxx $ High Yield Corporate Bond (-$1.06 billion, most of any ETF) and the SPDR Barclays High Yield Bond (-765.4 million, the second most), while also redeeming $577.4 million (the fourth most) from the iShares iBoxx Investment Grade Bond ETF, according to FactSet and ETF.com.

In turn, they pushed $251.4 million into the broader-based Vanguard Total Bond Market fund and reduced their duration exposure by putting $210.1 million into the iShares 1-3 Year Credit Bond.

The moves come amid a confluence of higher rate expectations and worries over how Dodd-Frank banking regulations will impact banks' ability to remain players in the fixed income markets. Blackstone CEO Stephen A. Schwarzman, in an op-ed piece Wednesday for The Wall Street Journal, warned that "a liquidity drought can exacerbate, or even trigger, the next financial crisis."

Christina Padgett, head of leveraged finance at Moody's Investors Service, said liquidity concerns are not a major problem for the high-yield portion of the market now, but there are challenges for the future.

"There's all this momentum today that says these companies are still liquid," Padgett said in a phone interview. "When they refinance, if the economy isn't as strong, if we're not much closer to the credit default cycle, that's a juncture that we are concerned about."