Beware hidden dangers in bond funds
Regulators and money managers are raising alarms about a growing threat to bond funds and their investors. The concerns revolve around “liquidity” — the ability to buy or sell a security at a decent price within a reasonable period of time.
As a result of new regulations enacted since the financial crisis, broker-dealers — the bond market’s middlemen — have sharply curtailed their trading activities.
At the same time, corporate bond issuance has surged as companies seek to take advantage of ultra-low interest rates. So in a larger market with fewer middlemen facilitating trades, it’s getting tougher for mutual funds to buy and sell bonds.
As investment-grade corporate bond issuance has soared, corporate bond turnover — a measure of trading volume relative to the size of the market — has declined steadily, according to a T. Rowe Price report. And while “the high yield market has always been illiquid, in the investment-grade and Treasury market, it’s new to have less liquidity,” said Elaine Stokes, a fixed-income portfolio manager at Loomis Sayles.
To adapt to a lower-liquidity market, some funds have set up lines of credit they can tap if shareholder redemptions surge. Others are holding more cash and highly liquid high-quality bonds.
“On the worst days, when bonds are quoted down the most, not a lot is trading,” Stokes said. “But as things start to recover, that’s when people start to let go of the bonds.”
Assess your exposure
As a bond-fund investor, you probably can’t avoid liquidity risk altogether — at least, not if you want to get a decent yield. “There is a trade-off,” said Sarah Bush, director of manager research for fixed-income strategies at Morningstar. “You get paid for taking liquidity risk.”
You can, however, get some sense of your funds’ liquidity risks by delving into the portfolio holdings. Review each fund’s quarterly reports, or go to Morningstar.com to stay up-to-date on current holdings. Cash, Treasuries and high-quality agency mortgages are generally the most liquid holdings, Bush said.
