Bonds are set to once again be at the center of a financial storm. This time, the problem will start on Main Street, when individual investors see interest rates rise.
When interest rates rise, bond funds will drop in price. If investors sell to stop their losses, the market might not be liquid enough to meet their demands.
Unlike stock markets, bond markets are not very active. On an average day, total trading in corporate bonds totals $20 billion. The Vanguard Total Bond Market exchange-traded fund, with about $110 billion in assets, holds $20 billion worth of corporate bonds. If the fund needed to sell quickly to meet redemption requests, the bond market could quickly become stressed.
As a group, mutual funds hold more than $500 billion in corporate bonds, an amount equal to about five weeks worth of normal trading volume.
In a market panic, liquidity becomes the most important factor. This was the reality that led to the founding of the Federal Reserve.
In October 1907, a market crash was caused by a single speculator using borrowed funds and too much leverage in an attempt to corner the market in a stock called United Copper. Knickerbocker Trust, the bank that made the loans, suffered a liquidity crisis. The looming failure of this bank threatened the entire financial system. Treasury Secretary George Cortelyou enlisted the help of banker J.P. Morgan. Teaming up with other bankers, Morgan redirected money between banks, found additional sources of credit and bought oversold stocks of healthy companies. Within weeks the Panic of 1907 was over.
A similar story unfolded in 2008. Speculators used borrowed funds and excessive leverage led to the collapse of several large Wall Street firms. In 2009, the Fed stepped in and provided liquidity to the markets, an action that ended the bear market.
This time, Wall Street firms have sold illiquid investments to Main Street under the illusion of liquidity.
When bond investors try to take their money out of bond funds, which is likely to happen when interest rates rise and account values drop, the bond market lacks the liquidity to meet their demands. The Fed might be at the limit of what it can do, and the market crash sure to follow could make the 2008 bear market seem like a mild correction.
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