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.