If calamity breaks out in the bond market, it's largely mom and pop investors who may end up calling the shots when it comes to corporate bonds.
That's because the mutual fund industry controls a hefty 25 percent of the corporate bond market, with foreigners the other big holder with about the same amount. So, when it comes to stomaching losses in the event of a sharp interest rate move, these Main Street and overseas investors may not take it well, and their immediate response could be: Sell!
"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.
When mutual fund investors sell, their funds do as well, so a rush in redemptions could create cascading selling pressure—and rising yields.
"You can sell these mutual funds with a point and a click, and the bonds that back them aren't quite as easy to sell, especially in the Volcker rule world," said Jack Ablin, CIO of BMO Private Bank. Ultimately, he said they should bounce back and liquidity problems may be painful but are temporary.
That worries Wall Street since the lack of liquidity in the bond market may make create even bigger losses as some bond names are sold. And the ones that could suffer most are the big liquid bonds favored by mutual funds.
"Essentially, mutual fund XYZ is not all that different than fund ABC. They get money from the same investor 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.
He said bond ETFs would also be a factor, but mutual funds hold the lion's share. "That's a bigger part of the (potential liquidity) problem, and I don't know that it gets enough attention," Antczak said.
Investors started to yank money out of bond funds last week, reacting to a monthlong selloff and unusually high volatility in Treasurys. Overall bond fund outflows were $2.76 billion compared to an inflow of more than $4 billion the week before, according to Bank of America Merrill Lynch.
BofA points out that high-grade funds reported an inflow of $1.05 billion, however, because of rising inflows to short-term bonds while investors rotate out of longer duration. BofA said high-yield funds saw a $2.4 billion outflow, driven by ETF selling.
Corporate bonds this month have been generating total negative returns for the first time in a while. But strategists say interest rates would have to continue to rise quickly and chaotically for serious problems to emerge.
The average return for funds in the Morningstar corporate bond category, as of Thursday, was negative 0.89 year to date.
Strategists blame the lack of liquidity in credit markets, in part, on a regulatory reshaping of the financial industry after the financial crisis. Institutions are less able to use their capital as they once did, and dealer balance sheets are dramatically reduced.
At the same time, the low interest rates of the post-financial crisis years and the search for relative safety drove individual investors into bond mutual funds, making these funds the largest and fastest-growing investor class holding corporate debt. This doubling of holdings by mutual funds paralleled the cutback in activity by financial institutions.
U.S. corporate bonds, also thanks to low rates, 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.
Rate strategists at UBS 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."
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 its recent peak of 2.50 percent early Thursday. Yields have since come down and were lower Friday.
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.