The U.S. bond market has been considered a “safe haven” for investors for generations. You might not get the biggest return on a blue-chip corporate bond or U.S. treasury note, but you could sleep at night because you didn’t have to worry about volatility or notable risk in your investment. That is not the case any longer.
As the Wall Street Journal points out, bonds now seem “vulnerable as never before to price reversals and trading disruptions that could spill over and threaten financing for businesses and individuals.”
Keep in mind that the U.S. bond market is one of the largest financial markets in the world, holding $39.5 trillion in outstanding debt as of mid-2015, based on Securities Industry and Financial Markets Association data. Moreover, the U.S. bond market is almost 50% larger than all domestic stock markets combined, and nearly twice the aggregate size of the five largest stock markets in Japan, China and Europe.
Experts note that the bond market has been gradually morphing into a different beast since the financial crisis eight years ago. What used to be a competitive marketplace with rates truly based on credit risk, has been transformed by semi-permanent ultra low interest rates that led to debt issuance and greater investor risk taking. At the same time, tighter regulations are constraining financial institutions, and the rapid increase in size of asset managers and new methods from fast-trading firms are literally changing how bonds are bought and sold today.
Giant bond funds now dominate U.S. bond market
Perhaps the biggest change in the last few years has been the growth of large bond funds. It turns out that the rise of large bond funds has led to new risks for the market. Cross-ownership of the same bonds has increased dramatically with the new huge bond funds, which greatly boosts the likelihood of contagion if just one manager starts selling, according to the IMF.
There is also the more generalized concern that investors do not know what is actually in their funds. Some analysts have pointed out that a market downswing could result in more redemptions of fund shares, so the funds will have to sell assets to raise cash, amping up the selling pressure in the market.
Over $1.5 trillion has flowed into U.S. bond mutual and exchange-traded funds over the last eight years, with just $829 billion moving into similar stock funds.
One scary statistic is that bond mutual and exchange-traded funds now own 17% of all corporate bonds, almost doubling from 9% in 2008. The IMF’s report late last year also noted that more-concentrated mutual-fund ownership typically leads to bigger price drops.
U.S. corporate high-yield bond issuance stayed below $147 billion until 2010, based on Sifma data, but given historically low interest rates has now doubled that figure in each of the past three years. Although defaults remain quite low, judging when they might start moving up is very difficult with interest rates close to zero six years into the “economic recovery”.
Bond market analysts further note the Fed’s recent decision to not hike interest rates makes it clear that bond yields will stay very low for at least a couple of years.
That said, frightening events like the “taper tantrum” in 2013 and the “flash crash” in the U.S. Treasury market last Oct. also make it clear that the bond market is much more fragile and subject to volatility than it has been in the past.