Bond Market Volatility Likely To Hit Normal Levels

Bond Market Volatility Likely To Hit Normal Levels
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OCEAN CITY — Bond yields continued to rise, with the 10-year U.S. Treasury yield jumping as high as 2.5% in June before pulling back. As bond yields have risen, prices have fallen, with outflows accelerating and bond market volatility creeping higher. These developments have rekindled investor concerns over bond market volatility and liquidity.

We expect bond market volatility to rise to more normal levels in the coming quarters, as the Fed begins to tighten policy. Less bond market liquidity contributes to higher bond market volatility. We broadly define liquidity as the degree to which an asset or security can be bought or sold in the market at the quoted price and without affecting the asset’s price. In the current period of central banks’ policy of low rates, liquidity has been effectively guaranteed by the nature of central banks’ intervention (e.g. quantitative easing programs). However, declining liquidity may no longer be masked by inflows into bond markets as the Fed stopped purchasing bonds. In this environment, we think assessing liquidity risks in bonds is much more important; we see an opportunity to reposition bond portfolios now. The potential for a disruption in liquidity should be of greater concern for investors who may need to sell securities on short notice than for investors who plan to buy and hold securities for extended periods or to maturity.

Clients with a longer time horizon should be more focused on achieving their goals than on responding to higher volatility or low liquidity in the bond market. Given our view of higher volatility and less liquidity in the bond market going forward, we also believe now is a good time for investors to ensure strategic allocations are consistent with their risk tolerance and objectives. How we got here We see at least two main drivers of reduced bond market liquidity: increased regulation of broker/dealers and a greater proportion of the fixed income market held by mutual funds and ETFs.

Given the increased regulation, it is likely that broker/dealers will maintain a lower-risk profile, which comes at a cost of liquidity for investors. A second driver of reduced bond market liquidity, in our view, has been the growth in market share of corporate bonds held in mutual funds and ETFs that offer daily liquidity. Investors in such funds have the ability to reduce their exposure to the asset class quickly during periods of market stress. This would accelerate the effects of rising rates on bond prices during periods of large investor redemptions as funds would look to adjust portfolios in a similar way in volatile markets, thereby reducing bond market liquidity.

Normally, less liquid issues trade at higher yields to compensate investors for the lower liquidity. However, as BofAML Credit Strategist Hans Mikkelsen notes, this compensation (or the liquidity premium) has diminished over the past year or so, as investors have reached for yield.

There is a mismatch in liquidity offered by investment funds with redemption terms that may be inconsistent with the liquidity of underlying assets. Additionally, there is a mismatch of client expectations for daily redemption terms that may be inconsistent with the liquidity of the underlying assets. Many credit funds hold illiquid credit instruments that trade infrequently in thin secondary markets.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)