Much has been written about so-called "liquidity" problems in the bond market. Big banks' CEOs decry the lack of liquidity because it manifests itself in reduced profits given additional capital requirements. Still, there have been notable shifts in bond markets that warrant the attention of investors.
The global bond market is ginormous (that really is a word). The Bank for International Settlements reckons there is over $80 trillion in fixed income, twice the size of all of the world's stock markets combined. In the United States alone, the bond market totaled $39 trillion at the end of 2014.
Furthermore, the number of individual bonds is exponentially greater than the number of stocks. While roughly 15,000 stocks trade on U.S. markets, hundreds of thousands of bonds vie for investors' attention within a complicated and somewhat opaque bazaar. Given the complexity and the number of issues, very few bonds change hands on exchanges. Most trades occur through broker/dealers that buy and sell from their own inventories or match up buyers and sellers in the "over-the-counter" market.
Developments in this complicated market have made it more difficult for would-be sellers to exit if many choose to do so simultaneously. This potential illiquidity is hardly a new phenomenon, but has been exacerbated by several factors subsequent to the Great Recession.
Bankers are partly correct about regulation restricting liquidity. Broker/dealers trade more popular bonds from their own inventory, acting as "market makers" who step in and buy from a seller if no counterparty can be found. This has traditionally been a profit center for the dealer banks and provides some limited liquidity. Regulatory changes require the banks to hold more capital in reserve as a partial bulwark against another banking crisis. Furthermore, memories of the last near-insolvency are still fresh enough to limit risk taking. These factors have made dealers less willing to hold inventory, making it more difficult and costly for sellers to bail in a market bereft of buyers.
Additionally, central banks have crossed the line from their appropriate role in maintaining price stability into manhandling of the bond markets through interest rate price fixing. The full extent of the distortion is yet unknown, but unwinding this unprecedented intervention is sure to amplify volatility in fixed income markets. Not only has a zero rate policy forced conservative investors into riskier positions, its reversal threatens to impose unexpected losses on a class of investors who least expects it: holders of bond mutual funds.
Importantly, an increasing share of fixed income is now held in mutual funds and ETFs. Assets in bond funds have more than doubled since 2007 to nearly $3.5 trillion in the US alone. These vehicles provide diversification and efficiencies but may be laying a trap for would-be sellers next time there are significant outflows. Since baseline rates are so low, a typical investor in a bond fund will likely realize losses over the next year or two if rates just return to equilibrium.
Mutual funds return capital by selling enough bonds to cover your withdrawal. But what if everyone else decides to vamoose at the same time? Who will buy the bonds offered up for sale en masse? Hence the legitimate concern over potential illiquidity in the bond markets. It has been two generations since we witnessed a similar scenario in interest rates, during a period when funds played a much smaller role. We truly don't know how this one will turn out if and when the exodus begins, but the potential for losses is certainly a concern. Bond fund investors should carefully review positions and maturities to be sure they are comfortable with this risk.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.