Bond funds are in a bad spot, and it will probably get worse.
A crash to Earth for growth stocks and cryptocurrencies is one thing, but a sharp decline in mainstream bond mutual funds could spell enormous trouble. Signs are emerging of the beginnings of a potential downward spiral in these funds, which could ultimately lead to redemption halts and subsequent panic by retail investors. That could pose the biggest challenge to the Federal Reserve’s plans to tame inflation through rate increases and quantitative tightening.
Bond mutual funds have now experienced two consecutive weeks of outflows totaling $30 billion, with exchange-traded funds adding an additional $10 billion. It may not seem like a big deal — and it isn’t yet — but these funds almost always take in cash, and it doesn’t take long for a little outflow to become a lot. Moreover, the last two times these funds experienced periods of significant outflows, the Fed did or said something dovish to turn it around. Now these outflows may not have been the cause of the central bank’s actions — although they were most likely at least a factor given how these funds manage more than $5 trillion of aging baby boomers’ retirement investments — but they are correlated. At least as of late.
The problem for these funds is they own a bunch of bonds that are going to be worth less if all the new bonds coming out offer higher yields. That’s why the prices of bonds are down and their returns are diminishing. And there’s really nowhere to hide. Corporates, Treasuries, mortgages, long term, short term, international, you name it, they are all red this year. And when bond funds start posting negative returns, money tends to start flowing out.
When they experience outflows, they usually start by dipping into their cash or selling any bond ETFs that they own as liquidity reserves. This is already taking place; the most liquid bond ETFs — HYG, LQD and TLT, for example — are experiencing billions of dollars in outflows already this year. Mom-and-pop investors aren’t selling these ETFs; they are professional money managers. Once they sell all their ETFs and the outflows continue, they will have to sell actual bonds, which will lower prices and result in negative returns, which will spark more outflows which will force them to sell more bonds which will lower prices and their returns. You get the idea. This downward spiral would start to dry up liquidity in the bond market and could ultimately lead to the fund having to halt redemptions. Panic would ensue.
The prospect of halting redemptions — and their much larger size — is why bond mutual funds are arguably a bigger risk to market stability, and the Fed’s hawkish plans, than bond ETFs, which many have pegged as the most serious threat. While ETFs won’t escape misery, they have only a fifth of the assets, and they have the release valve of trading on an exchange. Their shares may trade at a discount to net asset value, but they will trade.
I’m not the only one pointing out this potential problem. Janet Yellen said the same thing a year after the March 2020 crisis in response to questions from Senator Elizabeth Warren:
“I believe it is important to look very carefully at the risks posed by the asset-management industry, including BlackRock and other firms. FSOC began to do that, I believe, in 2016 and 2017, but the risks it focused on were ones having to do with open-end mutual funds that can experience massive withdrawals and be forced to sell off assets that could create fire sales. That is actually a risk we saw materialize last spring in March.”
Had the Fed not stepped in and thrown the kitchen sink at the bond market at that time, it’s entirely likely that some of the country’s biggest mutual funds would have halted their redemptions. They experienced two consecutive weeks of $90 billion outflows. One example is the $143 billion Pimco Income Fund, which declined 13% in the 30 days before the Fed acted. This triggered outflows of about $14 billion. All in all, the fund shrank 18% in a few weeks. How much more of this could the Pimco fund have withstood before it would have needed to halt redemptions? In India, where the central bank didn’t act as aggressively as the Fed did in the U.S., Franklin Templeton halted redemptions on about half a dozen of its active bond funds.
Of course, it’s possible that outflows from bond mutual funds are much more orderly — or even reverse and turn to inflows — and that these funds are able to adapt to the rising rate environment without the downward spiral kicking in. But as the Fed embarks on tightening monetary policy, investors and policy makers need to keep a close eye on which way the money flows and how funds are able to respond.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
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