Investors may love bonds now, but just wait

$3 trillion trade to fear
$3 trillion trade to fear   

If interest rates rise too quickly, spooked mutual fund investors could set off a liquidity trap in the corporate bond market—potentially generating more selling and even steeper losses, as they rush for the door.

That's a concern on Wall Street, since interest rates have been rising rapidly in the past several weeks, and corporate bonds this month have been generating total negative returns for the first time in a while. The average return for funds in the Morningstar corporate bond category is negative 0.89 year to date. The lack of liquidity in credit markets, which were reshaped by post-crisis reform and industry restructuring, can only exaggerate the trend with dealer balance sheets dramatically reduced.

So far though, bond investors still seem to love their funds—a net $5.3 billion went into bond mutual funds and exchange-traded funds in June, even though they are down nearly a percent, according to TrimTabs' data. A net $884.2 million went into investment-grade bond mutual funds in the four weeks ended June 3, according to Thomson Reuters.


Tim Boyle | Bloomberg | Getty Images

As retail investors reached for yield in a low-rate environment, bond mutual funds became one of the largest and fastest growing investor classes holding corporate debt.

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At the same time, financial institutions have cut back on their bond holdings and dealer balance sheets are historically low. Mutual funds basically doubled their share of corporate debt in the past decade—holding nearly a quarter of the market now, while overseas investors have about the same amount, according to Citigroup.

U.S. corporate bonds have seen record issuance as corporate bond fund holdings have surged, adding $3.3 trillion more supply to the market in the last decade, according to Citigroup. Total U.S. bond fund assets, meanwhile, have swelled to $3.54 trillion as of March 31, up nearly a trillion dollars from five years ago, according to UBS.

"Part of the problem is the size of the market, but more importantly is who holds the bigger share of the market. There are 23 investor types ... households, pensions, insurance companies but the real growth has been very concentrated. You see an exponential increase in mutual fund money," said Stephen Antczak, head of U.S. credit strategy at Citigroup. Antczak said ETFs are a smaller concern, compared to the holdings in bond mutual funds.

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Strategists see the corporate bond market as vulnerable to selling pressure if fickle foreign investors pull money from U.S. assets but possibly even more so if retail investors start to get skittish about bonds. While the underlying credits may be strong, those funds are forced to sell when investors seek redemptions.


"Essentially, mutual fund XYZ is not all that different than fund ABC. They get money from the same investors base. They've followed the same strategy and have the same constraints. They're not going to be thinking about the world very differently," said Antczak.

UBS rate strategists this week reissued a study they did in early May, which examined what the point of pain might be for retail investors in those funds.

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"If we have a selloff exceeding 60 basis points in the single A corporate yield in a short period of time—and we are not quite there yet but close to it—that would correspond to something like 2.55/2.60 on the 10-year Treasury," said rate strategist Boris Rjavinski. "If we get to that point, that has historically triggered outflows ... we don't say it's a hard rule. In the past what followed was strong outflows."

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Rjavinksi said that is not a set "red line" but just guidance based on past investor behavior.

"Given that markets are sort of thin, that could sort of contribute to a further wave of selling," he said, adding yields could then move another leg higher.

"We call it a negative feedback loop," said Rjavinski. "Fixed income markets are not as liquid as they used to be. You get a first wave of selling that pushes prices lower, pushes yields higher and triggers more selling, and for a while that could feed on itself. We believe that's exactly what happened for several weeks back in 2013 during the taper tantrum."

Bond experts say more securities in the corporate bond market have become less liquid, and there is more trading by "appointment" on Wall Street. So, when mutual funds sell, they could cause bigger price swings as they try to unload holdings.

"I would say household names are more likely prone to this," as they are most widely owned by popular bond funds, Rjavinski said. "Very large companies with high credit ratings—chances are a lot of those are owned by mutual funds and ETFs."

Antczak said the trades should ultimately not have a problem clearing, but prices may take a take a potentially bigger hit because of the liquidity issue, which he says is also caused by the concentration of holdings, not just the changes on Wall Street.

"Liquidity is modest, and everybody is trying to do the same thing," said Antczak. "I would argue everything is vulnerable. I think there is a mentality when you suffer a shock that the most liquid paper is the first out the door."


Bond experts stress that the selling would not have to do with the underlying corporate bonds in the fund, but in the fact that rates are moving higher. Antczak said a slow rise in rates would not ruffle the market quite as much.

But it's the rapid jump that strategists are concerned about since returns would quickly turn negative but over a longer period of time bond fund investors could see better total returns due to coupon income. The recent rise in Treasury yields has caused some concern since it has been rapid, and if continues to move higher at a fast pace it would become a problem.

The 10-year Treasury yield for instance quickly rose from 1.92 percent on April 27 to 2.50 percent early Thursday.

The Federal Reserve meets next week, and while it's not expected to move on rates, many traders are looking ahead to the first hike in nine years in the month of September. Strategists say yields could continue to rise.

Liquidity problems are not just isolated to the corporate market, but have been reverberating through global bond markets. A reduced number of primary dealers, smaller trading desks and an unwillingness to use balance sheet capital have also exaggerated moves in Treasurys and in bunds, according to traders and strategists.

Antczak said regulators are actively discussing the problem, and he's talked to the New York Federal Reserve and the IMF about the issue as well as the Financial Industry Regulatory Authority.

"I think they want to understand the problem. They realize people have been talking about it," he said.