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Tuesday, July 22, 2014
How a market shock could make your bond fund unsellable

How a market shock could make your bond fund unsellable

Comment: Several things could trigger a stampede of sellers among bond investors – and there may be no buyers, says Brian Dennehy

A few weeks ago, remarks by the US Federal Reserve reminded us of the unthinkable: when you want to sell your corporate bond funds, you might be stopped from doing so.

Here we explain why and suggest what investors should do.

In June it was reported that America's central bank, the Federal Reserve, was concerned about investors not being able to sell their corporate bond funds if lots of them rushed to sell at the same time.

In particular they were said to be considering preventing investors making withdrawals from their funds in such circumstances. The reasons why they were concerned were twofold, and they are relevant to UK investors:

Before Lehman Brothers went bust in 2008 it was the investment banks that typically would offer to buy these better-quality bonds if a big seller (say a bond fund manager) wanted to sell. Well in 2008-09 the investment banks didn’t want to know, so with lots of sellers and few buyers the prices plummeted. This is what is called a liquidity problem – the market dries up

Since 2008, interest rates have been cut sharply, and in the UK they went to the lowest level since records began in the 17th century. This meant that those looking for a decent return on their money, without taking too much risk, had limited options – deposit returns were hopeless. Corporate bonds, despite the troubles of 2008-09, suddenly became massively attractive.

For example, from January 2009 to May 2014 the amount invested into these bond sectors almost doubled in the UK. There have been similar trends in the US.

But although amounts invested in these bonds has rocketed, the investment banks didn’t return to provide much needed liquidity to enable sellers to find ready buyers.

This doesn’t just hit investors who have a known investment in a corporate bond fund. It can also hit those with so-called lifestyle pension. These automatically move more of your pension fund into bonds as you get older – but it is possible you could end up stuck in some of these funds just when you need access to the pension fund when you retire.

A very recent precedent

As stock markets began to collapse in 2008 corporate bonds were battered; when sellers entered the market there was no one to buy. There is no electronic dealing system with guaranteed prices for corporate bonds (in contrast to shares), and the typical buyers – the investment banks – were nowhere to be seen. Unexpectedly, it was the supposedly safer investment-grade corporate bonds that took the biggest hit. In the UK, a number of funds fell by more than 30pc within six months – a big hit for supposedly low-risk investments.

What might trigger a rush for the exit?

Frankly it could be many things we could now anticipate, and some that aren't really in focus, at least yet. In the former category might be a sudden about-turn by central banks, in the US in particular, that interest rates are heading up soon; loud warnings by central banks about risks in the bond markets; a bank collapse in Europe or the US rippling around the globe; an inflation shock such as oil prices spiralling on the escalation of tensions in Ukraine and the Middle East; collapse in the Chinese banking system; or spiralling bond yields in Japan.

These can happen any time, as the timing of shocks by definition cannot be known in advance.

But for now, and until such a shock occurs, the outlook is dull rather than disastrous. Merely dull because although we believe it is likely that the 30-year bull market in bonds is over, they will not turn sour overnight (except for that shock potential). The reason is that there are vast sums washing around the globe looking for a home, so, if bond prices fall a touch, yields will go up and make them look more attractive in a world of very low interest rates.

What should investors do?

The outlook for corporate bonds is dull rather than disastrous.

But if there is a shock, and the possibility is very real, corporate bonds could fall very quickly (remember the 2008 precedent).

If you remain heavily in corporate bond funds, use recent price strength to reduce holdings. There are lower-risk alternatives for the money you withdraw, such as the Kames Property Income fund.

Brian Dennehy is the managing director of FundExpert.co.uk, the fund research and dealing website

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All of the provided information is believed to be accurate, however errors are possible. The opinions in the Commentary section do not necessarily reflect the opinions of GoldIRAS.com. Past performance of any investment is no guarantee of future performance. All investments have risk.
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