After spending much of the final weekend in June poring over worrisome news from Greece, money manager Raman Srivastava set his alarm for 2 a.m. on Monday and quickly left for the office. Srivastava, head of global fixed income at Standish Mellon Asset Management in Boston, downed four cups of coffee and ate doughnut holes at his desk as he waited for London’s stock and bond markets to open at 3 a.m. Already, the euro was falling, and Asian stock markets had plunged. Investors were reacting to Prime Minister Alexis Tsipras’s surprise decision to hold a referendum on austerity measures Greece would need to adopt to get a financial lifeline. While it’s true that investors have been pondering the consequences of a Greek meltdown for the better part of four years, says Srivastava, “you never know how things are going to play out.”
For months, concern had been spreading on Wall Street and in Washington that the bond market might not be able to handle a massive selloff—that if too many investors decided to sell at the same time, there wouldn’t be enough buyers, and bond prices would plunge, or the markets would freeze, as they did during the 2008 credit crunch. On Monday, June 29, it seemed as if that moment might be at hand. Not only was Greece on the verge of default, Puerto Rico warned on Sunday that it couldn’t pay its $72 billion in debt.
The market wobbled a bit that morning. Greek bond prices plummeted, and investors flocked to U.S. Treasuries, a favorite haven in times of crisis. At the end of the day, though, the market passed its stress test. There was no mass selling. The $15.7 billion of dollar-denominated corporate bonds that exchanged hands was the lowest in more than a month, according to the Trade Reporting and Compliance Engine, the Financial Industry Regulatory Authority’s bond-price reporting system. “It was business as usual and wasn’t as violent or panicky” as some feared, says Henry Peabody, a bond manager at Eaton Vance.
Any sense of relief was temporary. “I wouldn’t look at yesterday as any indication that markets are perfectly situated to absorb risk,” Jim Caron, a money manager at Morgan Stanley Investment Management, said on the Tuesday after the eventful weekend. As he and other traders and investors see it, the real test will come when the Federal Reserve starts raising interest rates for the first time in almost a decade, eroding the value of existing bonds.
With the Fed expected to act later this year or early in 2016, Finra has begun meeting with some of the market’s biggest participants to discuss how they can make sure that, when sentiment sours, there’s enough “liquidity”—or trading activity in the market—to make it easy to buy and sell bonds without knocking prices down sharply. The U.S. Securities and Exchange Commission is drafting rules for mutual funds to ensure they have plans in place to meet investor demands for cash.
Bond traders are already focusing on liquidity. Spain, for instance, must pay more than Italy to borrow money for 30 years, even though Spain is considered safer by credit raters. Why? The Italian bond market is twice as big as the Spanish one, and therefore more liquid. The same thing is happening in other places around the world. Bonds in smaller, less-active markets such as Finland, Singapore, and Canada are starting to fall out of favor. “Liquidity is our No. 1 criteria in country selection,” says Olivier de Larouzière, the head of European interest rates at Natixis Asset Management in Paris.
Liquidity is a worry in bigger markets, too. The U.S. corporate bond market has ballooned by $3.7 trillion during the past decade, with almost all of that growth concentrated in the hands of mutual funds, foreign investors, and insurance companies, according to Citigroup. Globally, the 20 biggest money managers hold 40 percent of all bonds, Bank for International Settlements (BIS) data show. At the same time, Wall Street banks, which traditionally acted as middlemen and helped cushion large moves in the market by buying bonds when a lot of investors wanted to sell, have retreated from that role because of postcrisis regulations aimed at making the banks less risky.
The concentration in the bond market could be a problem because it means fewer big participants are available to sustain trading in tough times. “The growing size of the asset management industry may have increased the risk of liquidity illusion,” BIS economists wrote in a June report. “Market liquidity seems to be ample in normal times but vanishes quickly during market stress.”
Aberdeen Asset Management has arranged about $500 million in credit lines to fund redemptions in the event of a bond market selloff, according to Chief Executive Officer Martin Gilbert. “It will get ugly” if either Greece exits the euro or the Fed starts raising interest rates, he says. Since the start of 2013, BlackRock, the world’s largest money manager, has more than quadrupled the amount its mutual funds can collectively borrow to meet withdrawals.
Along with arranging credit lines, fixed-income managers have been loading up on cash and securities they can sell easily, such as Treasuries and bank bonds—which are by far the most heavily traded securities in the U.S. corporate debt market. “No matter what I think of Treasuries, I have one big reason to own Treasuries: They’re liquid,” says Pascal Blanqué, global chief investment officer at money manager Amundi. So in a market panic, Treasuries, the safest securities, could also be the ones money managers dump if investors want their money back. “If you see yields going higher and that triggers redemptions in fixed-income funds, what do you sell to raise cash?” asks Michael Lorizio, a senior bond trader at Manulife Asset Management. “You sell what you can sell, Treasuries.”
—With Cordell Eddings and Lucy Meakin
The bottom line: Regulators and money managers are trying to ensure the bond market functions when the Fed starts raising rates.