Bond Market Has $900 Billion Mom-and-Pop Problem When Rates Rise

June 23 (Bloomberg) -- Holland & Co Chairman Michael Holland discusses the markets and college endowments on “Bloomberg Surveillance.” (Source: Bloomberg)

It’s never been easier for individuals to enter some of the most esoteric debt markets. Wall Street’s biggest firms are worried that it’ll be just as simple for them to leave.

Investors have piled more than $900 billion into taxable bond funds since the 2008 financial crisis, buying stock-like shares of mutual and exchange-traded funds to gain access to infrequently-traded markets. This flood of cash has helped cause prices to surge and yields to plunge.

Now, as the Federal Reserve discusses ending its easy-money policies, concern is mounting that the withdrawal of stimulus will lead to an exodus that’ll cause credit markets to freeze up. While new regulations have forced banks to reduce their balance-sheet risk, analysts at JPMorgan Chase & Co. (JPM) are focusing on the problems that individual investors could cause by yanking money from funds.

There’s a bigger risk “that when the the Fed starts hiking in earnest, outflows from high-yielding and less-liquid debt will lead to a free fall in prices,” JPMorgan strategists led by Jan Loeys wrote in a June 20 report. “In extremis, this could force a closing of the primary market and have serious economic impact.”

Liquidity Risk

Last week, Fed Chair Janet Yellen said she didn’t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt. Even though it may be concerning that Bank of America Merrill Lynch index data shows yields on junk bonds have plunged to 5.6 percent, the lowest ever and 3.4 percentage points below the decade-long average, the outlook for defaults does look pretty good.

Photographer: Pete Marovich/Bloomberg

Janet Yellen, chair of the U.S. Federal Reserve. Last week, Yellen said she didn’t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt. Close

Janet Yellen, chair of the U.S. Federal Reserve. Last week, Yellen said she didn’t see... Read More

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Photographer: Pete Marovich/Bloomberg

Janet Yellen, chair of the U.S. Federal Reserve. Last week, Yellen said she didn’t see more than a moderate level of risk to financial stability from leverage or the ballooning volumes of debt.

Moody’s Investors Service predicts the global speculative-grade default rate will decline to 2.1 percent at year-end from 2.3 percent in May. Both are less than half the rate’s historical average of 4.7 percent.

Forecasts for bond yields also show little angst about rates rising very quickly. Investors have gone back to funneling money into bonds and economists have lowered their predictions for how much benchmark Treasury yields will rise by year-end.

All of this doesn’t mean the bond market is stable, at least according to the JPMorgan strategists. The analysts said central banks are focusing their bubble watch on leverage and the banks, “but may miss vulnerability to liquidity.”

BlackRock’s Concern

That concern is also revealed in BlackRock Inc.’s pitch in a paper published last month that regulators should consider redemption restrictions for some bond mutual funds, including extra fees for large redeemers.

A year ago, bond funds suffered record withdrawals amid hysteria about a sudden increase in benchmark yields. A 0.8 percentage point rise in the 10-year Treasury yield in May and June last year spurred a sell-off that caused $248 billion of market value losses on the Bank of America Merrill Lynch U.S. Corporate and High Yield Index.

Of course, yields on 10-year Treasuries (USGG10YR) have since fallen to 2.6 percent from 3 percent at the end of December and company bonds have resumed their rally. Analysts are worrying about what happens when the gift of easy money goes away for good.

To contact the reporter on this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage

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