Should You Worry About Bond-Market Liquidity?

Let's say you owned 100 shares of a stock--we'll call it Amalgamated Hat Blockers--because you thought hats were making a comeback, and that hat blocking would be a natural beneficiary of the trend.

Unfortunately, the hat business never took off, and you decided to sell your stock. You called your neighbor, Jim, and asked if he'd like to buy it. No deal. You called everyone else in the neighborhood. Nobody else wanted it, either. You were stuck with your stock--and what's more, because there's no price, you have no idea what it's worth.

Sound weird? But that's roughly how the bond market works. "It's very much a make-the-phone-call, know-where-the-bodies-are-buried market," says Elaine Stokes, a comanager at

In financial terms, the ability to buy and sell something quickly and easily at a reasonable price is called liquidity. Big, robust markets like the one for ultrasafe Treasury securities are highly liquid, even in bad times. (Bear in mind that just because you can sell an investment quickly doesn't mean that you won't take a loss.)

And most times, the corporate- and municipal-bond markets are highly liquid, too. But the lower a bond's credit quality, and the smaller the issue, the greater the likelihood that you'll have difficulty selling it in a downturn. When Lehman Brothers collapsed in 2008, high-yield, low-quality junk-bond prices collapsed, sending yields to a record 22.14%.

At the same time, exchange-traded funds saw huge gaps open between the ETF's share price and the value of its holdings. "You saw funds trading at a 10% discount," says Shane Shepherd, head of macro research at Research Affiliates in Newport Beach, California. The mechanism that normally keeps that gap tight didn't work because, for many bonds, there simply wasn't a price.

Unfortunately, liquidity has declined in the bond market since then, for several reasons. One traditional source of liquidity has been bank proprietary trading desks, which would buy and sell bonds to make a profit for the bank. The Dodd-Frank financial reforms made it harder for big banks to speculate on their own accounts. (The bill did this to keep taxpayers from having to pay for banks' trading mistakes). But bank proprietary trading desks did act as a significant source of liquidity in the bond market.

As the number of market makers has declined, the bond market has ballooned. Companies have been quick to issue debt at today's low interest rates. "It's like the house has gotten bigger, but the doors have gotten smaller," says Loomis' Stokes.

And bond traders have gotten less accommodating. If an investment bank helped bring a bond public, it would often make a market in the bond, Stokes says. "It used to be understood that if you called the dealer who brought the bond to market, it was their obligation to make a market in the bond," she says. "Now it's what we call a 'work it' market--they don't necessarily feel they have to make a market the way they used to."

One of the peculiarities of liquidity is that it's always good in a bull market. It's when there's a crisis that dealers stop answering their phones, because no one wants to get stuck with a lousy bond that could get even lousier. And in a bad market, it's the junk bonds that get hit hardest, because they are at the highest risk of default.

Unfortunately, many newly issued high-yield bonds are junkier than usual--a trend dubbed "covenant-lite." "A bond is an agreement between the borrower and the lender, and the contract can say any number of things to protect the purchaser of the bonds," Shepherd says. "We're seeing a lot of bonds come to market without those covenants."

And even Treasury liquidity isn't what it used to be, Stokes says. Bids tend to be smaller and more volatile during the day, leading to greater volatility in Treasury yields and prices.

Banks, of course, are using the liquidity problem to complain that the Dodd-Frank restrictions are too onerous. But the Federal Reserve seems more concerned about avoiding another 2008 crisis. "The Fed is basically saying that it's more important to have your financial house in order than to provide liquidity to the markets," Stokes says. "They have moved risk off the dealers' books and into the hands of the investor."

How concerned should you be? If interest rates drift up gradually--as Morningstar's director of economic analysis, Bob Johnson, expects--then the potential for a liquidity crisis is relatively low. If, however, rates rise faster than expected, triggering an economic slowdown and an increase in corporate defaults, then the odds of a liquidity problem increase.

Unfortunately, defaults have started to rise recently, thanks in part to the collapse in oil prices. The number of bonds yielding more than 10 percentage points more than comparable Treasuries, a traditional measure of risk in the bond market, has been rising, Stokes says. And Moody's expected default rate for corporate bonds the next 12 months is 3.45%, up from 2.01% now.

"I'd caution investors to be cognizant of the risks they're taking," says Research Affiliates' Shepherd. "Own the safer credits. On the high-yield side, I wouldn't touch B rated bonds right now." In addition, holding some shorter-term securities doesn't hurt, either.

In a worst-case scenario, you could own a high-yield fund that's swamped by redemptions but doesn't have enough cash to meet redemptions. Management would have to sell its best, most liquid holdings to satisfy redemptions, leaving the fund with a portfolio of ugly bonds that nobody--especially you--wants.

That's the worst case. Stokes, however, says that for investors with a long-term outlook, the occasional market panic is an opportunity--provided you invest in a fund that has enough cash on hand to meet redemptions and buy bonds getting unfairly squashed by panicked selling. "You have to be flexible and have a long-term view," she says.

John Waggoner is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.