Bonds represent safety and stability to most investors — but with questions over the future of monetary policy and demand for income-generating products, are they still ballast for portfolios?

As the U.S. Federal Reserve searches for ways to raise interest rates, bonds can no longer be assumed to be safe havens, says Dave Haviland, a relationship manager at Needham, Mass.-based Beaumont Capital Partners.

Haviland argues that a spike in interest rates could lead to a selloff in bonds, possibly setting off a liquidity event or a long-term bear market across fixed income.

“It could come as a shock to a retiree relying on their portfolio to give them income if all the sudden they open their statements and see their bond funds have had significant losses,” Haviland says.

Bond markets have become especially volatile as of late, with yields on the 10-Year Treasury, often considered a paragon of stability, moving from around 1.36 percent in early July to well over 1.6 percent in early September — signaling a fall in bond prices.

Much of the volatility surrounds the will-they, won’t-they speculation around whether the Federal Open Market Committee will raise interest rates at its meeting later in September. Currently, the market does not expect an increase: Federal-funds futures still place the likelihood of a rate hike at around 30 percent.

Haviland posits that if the Fed were to begin raising rates with the markets unprepared, the response from investors could create a cascade of bond selling.

“If all of the sudden there was a bond sell off, it could trigger a concurrent equity sell-off as these models start seeing valuations that are less compelling and they start selling,” Haviland says. “I don’t believe this is imminent, but the concept is certainly there. Our concern is that a rise, even a modest rise in interest rates could have oversized events on both the bond and the stock markets.”

As interest rates and returns have declined, investors have chased higher-yielding products, allowing additional risk into their fixed income portfolios by assuming longer durations or accessing lower-quality credit.

“People have been forced up the risk spectrum by the central banks,” says Jeff Kilngelhofer, a portfolio manager on the fixed income team of Santa Fe, N.M.-based Thornburg Investment Management. “The Fed intentionally pushed down the yields of risk-free assets in hopes that pushing investors out on the risk spectrum would spur a circular environment of growth, and to some extent they’ve been successful.”

By doing so, many investors have also exposed themselves to increased liquidity risks — the possibility that when they’re prompted to sell their holdings, they won’t be able to find a buyer.

Bond market liquidity has three elements: breadth, which is the difference between the bond’s bid and ask spread; depth, the impact of a trade on market prices; and resiliency, how long it takes to execute an order and how long it takes for prices to bounce back after a large transaction. Traditionally, bonds with narrow bid-ask spreads are considered more liquid, as are those that can be bought and sold without major price disturbance in the market.

A liquidity event occurs when volatility and economic turbulence spooks these risk-takers to sell their holdings. An unanticipated interest rate hike, like the one recently predicted by DoubleLine founder Jeffrey Gundlach, could be exactly the issue to cause volatility and turbulence.

That’s because bonds have become more sensitive to interest rates changes as their coupon rates — the amount of interest they pay based on their face value — have also gone down.

Haviland notes that if a 10-year U.S. Treasury loses 10 percent in a given year while the coupon was 8 percent, then the yearly total return would have been -2 percent. Now that a 10-year U.S. Treasury yields below 2 percent, the same price decline would result in a -18 percent total return.

In the post-war era, fixed-income liquidity events have for the most part been short-lived sell-offs and/or limited to high-yield bonds — episodic events often caused by external factors, not systemic events caused by a broken market.

Haviland argues that the size of the U.S. bond market, with federal debt of $19 trillion, makes the prospect for even a minor sell-off of 2 percent a major threat to global economic stability.  After all, two percent of $19 trillion is still a whopping $380 billion, a sum larger than the GDP of all but the largest 30 economies.

“If you’ve purchased bonds and all of the sudden they go down, and then they continue to go down, it begins to snowball,” Haviland says. “You have to step back and look at the size of the bond market and realize who is going to be the incremental buyer. If $400 billion goes up for sale, who is going to buy it? That’s a lot of money.”

When corporate and municipal debt is considered, total U.S. debt outstanding balloons to $60 trillion — if two percent of that sum was put on sale, $1.2 trillion of selling pressure would hit the U.S. bond market, Haviland notes.

If and when the Fed decides to increase rates, by definition bond prices decrease, losses mount and selling pressure increases, says Haviland. In such conditions, investors and advisors might be hard pressed to find buyers for their bonds.

“If you’re asking me what to expect going forward, most likely is that interest rates are at some point going to rise, and when they do there’s going to be a negative impact on bond prices,” Haviland says. “It doesn’t matter whether it’s the AGG, 10-year Treasuries, or high yield debt, bonds have bear markets too and we’re in that perfect storm with all bonds.”

Since liquidity is itself a factor in bond pricing, there’s potential for a negative feedback loop once a sell-off begins — as bond owners sell off in response to something like an interest rate hike, they reduce the number of buyers participating in the market, as demand for bonds sags, prices drop as well, prompting more bond owners to attempt to sell their holdings and exacerbating the illiquidity of their bonds.

At Thornburg, Klingelhofer says that fears of a downturn in bond markets are exaggerated.

“Even if they hiked rates by 200 basis points in a year, the 10-year Treasury would approach 3.5 to 4 percent, which isn’t all that terrible,” Klingelhofer says. “All the while, it will still provide ballast in the portfolio with a negative correlation to the risk portion of that portfolio. Nevertheless, the entire fixed-income universe is less attractive now that it was previously, for sure.”

Ironically, volatility and bond prices and yield is being caused not by interest rate policy, but from the market’s difficulty interpreting the Fed’s messaging, says Ira Jersey, fixed-income strategist and portfolio manager at New York-based Oppenheimer Funds.

“We’ve come full circle to the problem of not having enough information like we did in the early 1990s when I started this business,” Jersey says. “The Fed released their first statement in 1994, on one of my first days. Until then, we had no information from the Fed, you had to go over the economic releases. Now we get instantaneous information, but most of it isn’t at all helpful.”

The Fed’s recent mantras — that any change in interest rate policy will be “data dependent” and gradual, aren’t that helpful when economic data is mixed. Though jobs and wage data have looked somewhat positive, economic activity has stagnated throughout 2016.

That means that fixed income managers have to take policymakers at their word when they project only incremental, gradual monetary tightening.

The St. Louis Federal Reserve addressed fixed income liquidity in October 2015, writing “It is, in fact, very difficult to know whether liquidity conditions are deteriorating in bond markets. Standard measures such as bid-ask spreads are of little help because historically narrow bid-ask spreads can widen suddenly in a liquidity event.”

The Fed noted that dealer inventories in U.S. corporate bonds declined from $250 billion in 2007 to around $50 billion in 2015, while the overall supply of corporate bonds had increased from $3.2 trillion to nearly $5 trillion in the same time period, attributed to de-risking among dealer banks. Bond buyers from Japan and Europe have also buoyed U.S. corporates and treasuries seeking better yields amid negative interest rates at home.

International interest in U.S. bonds makes the chances for a serious fixed-income liquidity event low, says David Mazza, head of ETF and mutual fund research at Boston-based State Street Global Advisors

“I think the fears of a liquidity event are overblown, at least in the near term,” Mazza says. “The foreign investment has kept inventories of Treasuries quite low, and we know that inventories of things like corporate bonds have decreased significantly, driven by regulation. There is some potential for a taper-tantrum type event, I believe that’s something the Fed is seriously concerned about, but that probably wouldn’t look like a catastrophic sell-off.”

Investors might also overestimate the Fed’s impact on bond prices, says Matt Brill, senior portfolio manager for Atlanta-based Invesco. After the Fed raised rates in December by 25 basis points, the 10-Year U.S. Treasury yield continued to drop, falling more than 60 basis points, the Five-Year dropped more than 50 basis points, and the Two-Year dropped more than 20 basis points.

Brill maintains that if bonds are used for their central purpose —stable, low-risk investments within a portfolio — and held until maturity, investors have little to fear, especially if their money is in high-quality areas of the market.

“The people who are afraid of a bond bubble or a liquidity event need to have bonds explained to them,” Brill says. “If you went out and bought a 10-Year Treasury and thought the current rate was a bubble, you would still make the current rate holding the bond. If you wanted to sell the bond, you could take a loss, but if you owned the bond to maturity there’s no credit risk. You don’t have to worry about what you signed up for.”