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By Christine Benz and Sumit Desai, CFA | 07-09-2015 03:00 PM

How to Protect Yourself Against Bond-Market Illiquidity

Morningstar's Sumit Desai explores which parts of bond market are most susceptible to a liquidity event, what fund managers are doing in response, and how investors can protect themselves.

Christine Benz: Hi, I'm Christine Benz for Bond-market liquidity was a hot topic at the recent Morningstar Investment Conference. Joining me to discuss that issue is Sumit Desai--he is a senior analyst at Morningstar.

Sumit, thank you so much for being here.

Sumit Desai: Thank you for having me, Christine.

Benz: Before we get into bond-market liquidity specifically, let's talk about liquidity in general and why it matters to investors.

Desai: To your point, I think liquidity can mean different things to different people. We joke around a lot amongst my colleagues that liquidity is a very fluid concept, but I think that actually is a true assessment of the market right now. Howard Marks of Oaktree wrote about the topic recently, and he had a very relevant definition of liquidity: It's not just the ability to sell an asset or security, but really the ability to sell a position at a price equal or close to its most recently quoted price. So, can you sell a position without impacting the price that the market is quoting you at?

Benz: At the conference, there was a lot of handwringing about potential liquidity problems in the bond market. Let's talk about what bond-fund managers think could be potential catalysts for some sort of an illiquidity problem for bond investors.

Desai: I think liquidity is interesting because it can come and go. You can have a very liquid market one day, and if sentiment changes the next day, it can go away. In terms of a catalyst--what can really cause an illiquidity event--obviously the hot topic of the bond market today is rising rates. We're coming off of this zero-interest-rate policy that we've had for a long time, so what's going to happen when the Fed raises rates and how are bond investors going to react? I think, in an environment where you see rising rates, that maybe could cause investors to run for the exits in a worst-case scenario. We've seen a lot of money going into this space over the past few years; the taxable-bond category has grown from just under $1 trillion to almost $3 trillion in a matter of less than 10 years--all pretty much in one direction. So, we've had a lot of money going into that space. In an experience where rates rise and investors flock out, that would be concerning.

Interestingly enough, we've seen situations like that. At the end of 2013 and the beginning of 2014, there was a situation where we actually did see the beginning of a lot of investors leaving fixed income in what was known as the "taper tantrum." That was a situation where a couple of months later, you saw a little bit of volatility; but within a couple of months, investors were able to go back into the market. They saw that valuations were a little bit more attractive, and they provided a little bit of a backstop, so that was an interesting impact.

Another interesting area that I think could potentially serve as a catalyst is any kind of credit event. We saw this in high yield in December 2014 when oil prices were plunging. Energy makes up a large part of the high-yield market, so I think that oil-price decline spooked a lot of investors, and they ran for the exits again. [As a result,] high yield experienced a little bit of a liquidity issue at that time as well. And I think this is the same within munis, for example, too. A credit event around Puerto Rico or Greece is really going to worry investors. That flight to quality may cause potential concerns around liquidity.

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