SEC’s Gallagher Sees Bond Bubble Hurting Retail Investors

The $10 trillion U.S. corporate bond market has been inflated by companies taking advantage of record low interest rates for the last five years, Securities and Exchange Commission member Daniel M. Gallagher said today.

“It clearly looks like a bubble,” Gallagher said at a market structure conference sponsored by the Security Traders Association. “You have a buildup of assets and you have to think about the downside if the bubble gets pricked.”

Retail investors would be most vulnerable to a sell-off that could result after the Federal Reserve raises interest rates and prices of outstanding bonds fall, Gallagher said at the conference in Washington. Banks have curtailed their fixed-income holdings as they seek to comply with new capital rules and Volcker Rule restrictions on risky bets.

About a quarter of corporate debt is owned directly by retail investors, and 73 percent of the $3.2 trillion of outstanding municipal debt is owned by small investors, he said.

Those investors are more vulnerable to sell-offs because they are less likely to understand the sensitivity of bond prices to interest rate changes, Gallagher said.

“I’m not convinced that the investors who have been chasing yield in this zero-interest rate environment really understand these products,” he said.

Average daily trading in the U.S. bond market fell to $809 billion in 2013 from $1.04 trillion in 2008, according to data compiled by the Securities Industry and Financial Markets Association. Bill Gross’s surprise departure from Pacific Investment Management Co. last week sparked sell-offs in some of his biggest wagers, such as inflation-protected U.S. government bonds.

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