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.
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