UBS: This is How Troubles in the Bond Market Could Impact Stocks

When would-be bond selling becomes actual stock-selling.

Sell what you can, not what you want, goes the old markets adage.

Analysts at UBS appear to have taken that strategy to heart with a new note detailing the stocks that could come under pressure in the event of a big squeeze in junk-rated bonds issued by companies with weaker balance sheets. The idea here is that the hybrid mutual funds carrying big portfolios of both debt and equities could be hard hit in the event of a long-awaited liquidity crunch that sparks turmoil in the corporate bond market.

In that scenario, such funds might find themselves having to meet redemption requests by selling more liquid assets from their portfolios, such as stocks and U.S. Treasuries, as opposed to harder-to-trade corporate bonds. 

In February we highlighted the risk that mutual funds were likely to be one means by which contagion from a sell-off in U.S. high yield would spread to other asset classes ... Unlike the other two credit-equity links, which are a higher cost of capital for junk-rated heavily levered small caps and a general reduction in risk appetite, it turns out that the mutual fund link directly affects large-cap highly-rated equity. Here we go deeper into the question of exactly which equities are likely to be affected if the US high yield credit market suffers a liquidity crunch.

Analysts Ramin Nakisa, Stephen Caprio and Matthew Mish point out that hybrid mutual funds and exchange-traded funds, "whose investors have no allegiance to asset class" now hold a sizable chunk of both bonds and equities. In fact, the breakdown of assets in this mercenary mutual funds looks something like this:

Source: UBS

On a more granular basis, Microsoft has the biggest dollar allocation for hybrid funds with $7.4bn currently stuffed into mixed-up mutual fund portfolios, followed by JPMorgan Chase at $6.3bn and Verizon at $5.8bn. 

While the scenario of bond market carnage that forces mutual funds to sell stocks and U.S. Treasuries is a long shot, it is still a possibility that is nevertheless worthy of investors' attention, the analysts conclude.

We believe we would need to have a systemic shock in order to trigger a liquidity problem in credit such as a further fall in oil, another sharp dollar rally or another negative growth surprise from emerging markets, hence this scenario is a tail risk, but one that in our opinion cannot be ignored.

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