'Severe' Danger Looming in Corporate Bonds: BofA

A jump in interest rates could spark an unruly exit from the $12 trillion corporate bond market, according to a new analysis.

Investors have been flocking to the relative safety of corporate and government debt while interest rates have stayed low and stock market tensions have run high.

But an expected shift out of fixed income - particularly top-quality investment grade - and into stocks coupled with a commensurate rise in interest rates and a much more easily traded corporate debt market could send tremors through the space, Bank of America Merrill Lynch said. (Read More: 'Easy Money' Will Help Stocks for Foreseeable Future: Roubini)

Corporate Debt Markets
Corporate Debt Markets

"A disorderly rotation out of bonds – characterized by higher interest rates and wider credit spreads – is the biggest risk for investment grade corporate bond investors this year," Hans Mikkelsen, credit strategist at BofA, said in a note to clients. "However, history offers little guidance about how much of an increase in interest rates would prompt such disorderly scenario and how it would play out."

Some indicators about this move, though, could be flashing now.

Stocks turned in their best January in 16 years to start 2013 and Treasury yields rose in unison. (Read More: Better Enjoy the Market Rally While You Can: Marc Faber)

The current 10-year yield at 2.02 percent does not meet Mikkelsen's criteria for what would trigger a "disorderly rotation" from investment grade corporates, but it is moving in that direction. The benchmark note began the year at 1.86 percent.

Mikkelsen estimates that a 2.5 percent yield would lead to what he would consider an orderly move out of the market, but a continued trek higher past 3.0 percent would be the game-changer.

BofA is not alone in its aversion to fixed income - Wells Fargo recently cautioned its clients about fixed income amid dangers from rising rates, and advised shifting 5 percent of their bond positions into stocks.

Because the corporate bond landscape has changed so much, history offers little guide about what could happen in a disorderly rotation. However, conditions in 1994 and 1999 are two periods that saw significant interest rate changes and corresponding outflows from the market.

Those cases saw investors pull about 10 percent of total assets out of corporate bonds. But even then, the parallels are different to draw primarily because of the different vehicles investors use to buy company debt.

In those days mutual funds were a bit player in the space, and exchange-traded funds even less.

But fixed income flows have surged and occupy huge parts of the fund industry, with $3.43 trillion in bond mutual funds, compared to nearly $6 trillion in equity funds.

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Bonds now are the biggest player in the $1.4 trillion ETF market with $238 billion of total assets, outpacing even large-cap stocks, which have $227 billion under management, according to industry tracker XTF. (Read More:

Corporate bonds had long been an illiquid asset - difficult to trade as investors usually either held bonds to duration or until the debt was called. But because ETFs trade like stocks and generally carry lower fees than mutual funds, they have changed the way the market operates. (Read More: Money Pouring Into Stocks 'Is Usually a Negative Sign')

"The key problem is that, with the rise of bond funds and ETFs, individual investors now have a means to trade illiquid corporate bonds in a much more liquid manner," Mikkelsen said. "When interest rates rise and (net asset values) decline, we are concerned that redemptions will lead to a situation where too many illiquid underlying corporate bonds come out of funds – especially as dealers have little capacity to act as buffer in the new regulatory environment."

Corporate bonds are now 42 percent of mutual fund assets, compared to 24 percent in 1994 and 31 percent in 1999, while mutual funds and ETFs combine own nearly one-fifth of the entire corporate bond market, including high yield bonds.

Households, meanwhile, have shifted assets as well, with 13 percent of their portfolios consisting of bonds, according to BofA figures.

"Thus, if we were to experience outflows from bond funds of the magnitude seen in 1994 and 1999, the impact on corporate bonds this time would be much more severe," Mikkelsen said. "There is reason to suspect that households will play a more active role in rebalancing out of bonds, into stocks as interest rates increase."