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Citi finds fatal flaw in corporate bond funds and ETFs Add to ...

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Predicting market disaster has evolved into a lucrative industry. With most of its purveyors of doom – Marc Faber and Zero Hedge for instance – the sheer consistency of their respectively apocalyptic outlooks makes them easy to ignore. But when Citigroup Inc.’s main credit product strategist makes a coherent and terrifying argument more or less guaranteeing a global corporate bond market meltdown, however, it’s time to start worrying for real.

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In the past, large banks carried enormous portfolios of both investment grade and high yield debt issues and provided liquidity to the market – buying bonds when the market was weak and selling when it was strong.

Since the financial crisis, however, U.S. banks have responded to regulatory pressure over proprietary trading and capital requirements by drastically reducing their holdings – from about $300-billion to less than $100-billion – while mutual fund and ETF fixed income assets have almost doubled from just under $500-billion.

There’s $900-billion in corporate debt funds and ETFs and a tenth of that in the banking system so, there is no way the banks can offset a buyers strike in bond funds if it occurs.

Here’s how I envision a worst case scenario. Step one would see big bond ETFs like the $16-billion iShares iBoxx $ Investment Grade Corporate Bond ETF experience heavy selling. Step two, “buy the dip” bids would fail to show up and banks, mindful of the aforementioned pressures to hold smaller inventories of corporate bonds, would also step aside. Selling would accelerate. Step three, an already-spooked market would be driven lower by huge selling of the ETFs’ underlying holdings (by the underwriters of the ETFs and the mutual fund portfolio managers.)

Spreads, the yield differential between corporate debt and Treasuries, would blow out and losses would be extreme. Equities would fall, likely significantly, in recognition that a main driver of recent profits – the low cost of capital (the interest that must be paid on borrowed funds) – has climbed. Treasuries would rally, at least temporarily, in a flight to quality.

I really hope Mr. King is wrong and this never happens. But, the vast majority of the $900-billion allocated to investment grade and high yield debt is retail investment. History tells us that retail investors can be subject to selling panics when long-term investment trends reach exhaustion.

I wouldn’t call the scenario above probable, but it is far too plausible for my liking.

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