Investors are well aware of what a stock market meltdown looks like, but they may not understand or appreciate the implications of a credit correction. Yet some market watchers are warning a drastic tumble in bond markets is a real possibility. It's something average investors should keep in mind: they've been piling into bond mutual funds that would be hit in such a scenario – and their behaviour could worsen the effects.
Falling interest rates over the past decade has meant rising bond prices, delivering dazzling returns for bond mutual funds. Investors have responded by jumping in. Mutual, closed end and exchange-traded funds now own close to 20 per cent of all investment and high-yield corporate debt in the U.S.
In Canada, investors bought a net $19-billion worth of bond funds in 2012 (compared with total investment fund net sales of $30-billion), more than two and a half times larger than sales a year earlier, as they continued to trade out of equity funds. Investors in Canada now hold $132-billion worth of bond funds, according to the Investment Funds Institute of Canada – up from just $53.5-billion at the end of 2008.
The concern now is that interest rates rise too much, too fast. Rates on 10-year U.S. Treasury bonds have climbed markedly in recent months after hitting an all-time low last July. The rate hit 2 per cent last week for the first time since April (remember, when rates rise, bond prices fall). If they continue to rise to 3 per cent, there would be a "disorderly rotation out of bonds – characterized by higher interest rates and wider credit spreads," warned Bank of America Merrill Lynch credit strategist Hans Mikkelsen in a research note this week.
Here's where the worry lies, said Mr. Mikkelsen: Bond trading has typically been limited to professional traders dealing in a relatively illiquid market that was largely inaccessible to retail investors. But now, those investors effectively have liquidity through their fund units, and Mr. Mikkelsen worries they could stampede out of bond funds and into equity funds as their bond fund values decline.
"We are concerned that redemptions will lead to a situation where too many illiquid underlying corporate bonds come out of funds – especially as dealers have little capacity to act as buffer in the new regulatory environment … History offers little guidance about how much of an increase in interest rates would prompt such a disorderly scenario and how it would play out."
Investors would be stung while corporations would be doubly stung – by rising rates and widening spreads over Treasuries, dramatically increasing borrowing costs and impinging their ability to finance growth, hurting the overall economy.
That all sounds scary, but bear two things in mind: a gradual increase in rates wouldn't have nearly as severe an effect on investors. In addition, the likelihood of Treasury rates climbing to 3 per cent in a short period seems remote. It would take much stronger economic recovery than we've seen, and than economists expect, to prompt such a move. Plus, an increase to 3 per cent could throw the highly leveraged U.S. economy back into recession, and the U.S. Federal Reserve likely wouldn't stand for that.
Nonetheless, bond fund buyers should be aware of the risks at a time when falling rates seem to be a thing of the past.