“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.