Canadians have piled into bond funds in the past five years, but Citigroup research thinks it might be far more difficult to get out.
In industry parlance, an investment without liquidity is called a "Hotel California," echoing the Eagles' lyrics, "You can check out any time you like, but you can never leave." The inference is that when trouble starts and liquidity dries up, the investor can place sell orders all they want, but the actual trade won't happen without significant financial pain at a much lower price than expected.
Matt King, Citigroup's global head of credit strategy, believes Hotel Californias – credit investments where underlying liquidity will dry up quickly in the event of a sell-off – are everywhere in the current market. "... [A]lmost every institutional investor, in almost every market, seems worried about liquidity. Even if it's here today, they fear it will be gone tomorrow. The growing frequency of 'flash crashes' and [similar but less severe] 'air pockets' – often without obvious cause – adds weight to their fears."
Mr. King describes a number of reasons for these liquidity-driven bouts of volatility. These include the low trading volume for the underlying holdings of high-yield bond ETFs, regulations that limit market-making activities for major global banks and the huge global growth in open-ended mutual-fund investments. (Open-ended funds guarantee daily liquidity even if the fund holdings are illiquid and hard to sell.)
Above all, however, Mr. King singles out a familiar target.
"Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the 'same way round' [similarly positioned in the market with overweights and underweights] to a much greater extent than previously …. Every so often, when they start to doubt their convictions, they find that the clearing price for risk as they try to reverse positions is nowhere near where they'd expected."
Fixed-income and yield-oriented investors, institutional and retail, all hold the same fixed-income instruments and all of these things are tied to central bank monetary policy. The problem is that the most interventionist central bank, the U.S. Federal Reserve, has not only ended its quantitative-easing program, but is expected to raise the benchmark interest rate in September, removing stimulus further.
The risk is that investors will all head to the exits in these crowded trades at once and there won't be enough buying interest to keep markets orderly.
If there are going to be problems, the U.S. high-yield bond market will likely get hit first. Mr. King writes that until the 1980s, more than 50 per cent of corporate bonds were held by long-term investors such as pension funds and insurance companies. Since 2000, however, retail holdings of corporate debt have exploded from less than $2-trillion (U.S.) to more than $6-trillion while institutional buying failed to keep pace.
A rising rate environment will definitely pressure corporate bond prices. Individual investors are prone to sell when losses start and, in the corporate bond market, there are no guarantees that bids will be available. If not, the unit values of these bond funds will "gap down" and fall hard.
Mr. King believes that losses will be widespread across the credit complex as central banks withdraw stimulus and concludes his report on a surprisingly ominous note.
"Markets are liquid when they work both ways. Market participants, though, find themselves increasingly needing to move the same way. On the way in [to debt investments], investors have moved gradually, and their purchases have been offset by new issuance. The way out may not prove so easy; indeed, we are not sure there is any way out at all."
Follow Scott Barlow on Twitter @SBarlow_ROB.