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Worries are rising about whether lower liquidity in bond markets will accelerate future losses

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NEW YORK, N.Y. - If bonds start to tumble, should I sell my bond mutual fund?

It's a question investors are asking as expectations rise for a more volatile bond market. But a better question may be: How difficult will it be for my fund manager to sell?

Worries are increasing that some managers will have a tough time finding buyers for their bonds if a flood of investors tries to pull out of their funds at the same time. It's a concept called liquidity, and a lack of it can accelerate losses for bonds when prices are falling, at least in the short term. It would likely have less effect on fund investors willing to hold on through the volatility than those who sell amid a storm. But it's another risk that all bond fund investors need to consider.

The worries partially stem from new regulations that have led to banks holding fewer bonds on their balance sheets. Previously, banks' willingness to hold inventories of bonds offered a buffer when sellers in the market outnumbered buyers. Inventories of investment-grade and high-yield bonds at Wall Street banks and other primary dealers are now just 20 per cent of where they were in 2007, according to State Street Global Advisors.

The areas of the market most likely to be hurt by the liquidity concerns include corporate bonds, particularly high-yield bonds that are issued by companies with weak credit ratings, says Dan Farley, chief investment officer of the investment solutions group at State Street Global Advisors. Treasurys, the largest sector of the bond market, aren't a source of concern.

IT'S HAPPENED BEFORE.

Some bond fund investors are already familiar with the phenomenon, such as those focused on bonds issued by cities and other local governments.

Several times in the last six years, fear has pushed investors to rush for the exits out of municipal-bond mutual funds. Managers typically keep a portion of their funds' portfolios in cash, so they have some ready for departing investors. But when a flood of sell orders converge, it forces managers to sell bonds to raise more cash.

In past periods of low liquidity, when managers went looking for buyers for their muni bonds, they often found many others also looking to sell. That caused municipal bond prices to tumble, which further frightened fund investors, leading them to pull yet more money, and fueled even more forced selling.

Last year, the trigger was worries about rising interest rates and the creditworthiness of Puerto Rico and other municipal borrowers. Investors began withdrawing their money from muni funds in the spring, and the largest category of municipal-bond funds lost 3.1 per cent during the second quarter, according to Morningstar.

A financial analyst's highly publicized prediction for a wave of defaults in the municipal bond market sparked a similar rush for the exits in late 2010. Investors pulled $13.3 billion from muni bond funds that December, according to the Investment Company Institute.

The toughest conditions, though, were during the financial crisis in 2008, says John Miller, who leads the $95 billion municipal bond investing team at Nuveen Investment Management.

"In 2008, there was a feeling of being handcuffed," he says. The few buyers available demanded steeper price cuts, and for a smaller number of bonds than he was looking to sell.

BUYERS EVENTUALLY RETURNED.

Following each of those episodes, though, municipal bonds rebounded once the rush for the exits subsided. Miller's Nuveen High Yield Municipal Bond fund (NHMAX), for example, has returned 13.5 per cent this year after losing 4.7 per cent last year.

High-yield corporate bond funds saw a similar scare last month. Investors pulled out of such funds following warnings from the Federal Reserve that junk bond valuations may be "stretched" and worries that interest rate hikes may come sooner than expected.

That led to an average 1.2 per cent drop for high-yield bond funds last month, their first loss in 11 months, according to Morningstar. High-yield funds have recovered somewhat in the last couple weeks.

THE WORRIES AREN'T UNIFORM.

Some areas of the bond market are better insulated from the liquidity concerns. Buyers of high-quality bonds continue to outnumber sellers, for example.

"Where we operate, it's very healthy," says Rob Galusza, who runs Fidelity's Limited Term Bond fund (FJRLX), which invests in shorter-term corporate bonds and Treasurys. "People feel like they can withstand the volatility there."

The liquidity concerns don't mean investors should abandon their bond funds, but State Street's Farley says it could influence the timing for investors who are looking to either buy or sell.

It's impossible to know when the next liquidity scare could hit the bond market -- the trigger is likely to be an unexpected event that shocks investors.

But if everyone is exiting bonds, and a lack of liquidity is sending prices down even further, it may make for a good buying opportunity for those who were already interested in buying. Similarly, for those looking to sell, it may pay to do so before there's a run on the exits.

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