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.