Mom and Pop retail investors who have been holding municipal and corporate bonds are about to get whacked.
All signs point to significant declines in bond values. Look out for increased volatility and limited liquidity. Retail investors beware.
The junk bond market this week took a hit.
“Investors pulled $2.56 billion from U.S. junk-bond funds in the past week, the second largest outflow this year, as cracks appear in one of the few fixed-income asset classes to withstand the global bond rout,” according to Cordell Eddings of Bloomberg.
“The two-month jump in government bond yields worldwide is starting to catch up with speculative-grade company debt,” Eddings reported. “The pullback is slowing what had been a record pace of issuance, with sales of the securities poised for the slowest week this year.”
In the coming months retail investors should expect to see significant declines in the value of their bonds as yields go up on government and corporate bonds following signals from the Federal Reserve that a hike in interest rates is on the horizon. Remember, bonds values decline as interest rates increase.
The improving U.S. economy, coupled with increasing signs that the Federal Reserve will increase interest rates, are sounding a clear warning that bond prices are likely to take a hit before we know it.
One part of the increasing risk is structural.
“Large Wall Street banks, or dealers, are carrying a smaller share of bonds on their books, as regulations restrict the capital they can hold on their balance sheets,” according to a recent article in Bloomberg by Alexandra Scaggs. “Money managers, meanwhile, are holding a lot more of them. Dealer inventories dropped by 27 percent between 2007 and early 2015 while assets held by bond mutual funds and exchange-traded funds almost doubled.”
That means there is a dangerous and growing imbalance among banks bond holdings and those of money managers. Indeed, Goldman Sachs and Deutsche Bank are expecting “wide price swings and higher costs to get” a bond transaction done, according Scaggs.
When you think of the current bond market, consider a crowded theater with only one exit. How does everyone get out if someone shouts fire?
The other part of the risk is investor fear and anxiety.
“Prices on U.S. investment-grade bonds have fallen 1.1 percent in the first two days of June, a pace so fast it’s reminiscent of the notes’ 5 percent selloff in two months in 2013 when speculation emerged that the Federal Reserve was poised to scale back its bond buying,” according to Bloomberg’s Lisa Abramowicz. Bank of America Corp. strategists see the pain deepening from here.”
She continued. “The reason? Investors who like these bonds tend to prize safety and reliable returns above all. They plowed into corporate bonds, often instead of more-creditworthy notes such as U.S. Treasuries, for higher yields as the Fed purchased debt and held interest rates at record lows to ignite growth.”
“These buyers, in particular, don’t like to see losses on their monthly mutual-fund statements. When the prospects for their debt look shaky, they’ve often responded by yanking their money. And that’s what they’ll likely do now, according to Bank of America analysts.”
Remember the so-called “Taper Tantrum”, when bond prices were crushed in the summer of 2013? A redo is likely.
Bond investors beware. Take a hard look at your brokerage or retirement accounts and see how much you have allocated to bonds. Your bond portfolios are about to get whacked.